Purpose: proxy for cash profit

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is often used as a proxy for cash profit because it attempts to show a company's operational profitability before the impact of non-cash expenses and financing decisions. However, it has significant limitations as a true measure of cash profit.

What is EBITDA?

EBITDA is a financial metric that represents a company's earnings before deducting interest expenses, taxes, depreciation, and amortization. It is calculated by adding interest, tax, depreciation, and amortization expenses back to net income, or by adding depreciation and amortization to operating income. The purpose of EBITDA is to provide a measure of a company's core operating performance, stripping out factors like capital structure (interest), tax rates, and non-cash accounting entries (depreciation and amortization) that can vary significantly between companies or over time.

What is Cash Profit (Operating Cash Flow)?

Cash profit, often synonymous with operating cash flow, represents the actual cash generated by a company's day-to-day business operations. Unlike net income, which is an accrual-based accounting measure, cash profit focuses on the real cash inflows and outflows from core business activities. It indicates whether a business is generating or losing cash from its primary operations.

Why is EBITDA considered a proxy for cash profit?

EBITDA is considered a "loose proxy" for cash flow from operations because it adds back depreciation and amortization, which are non-cash expenses. These expenses reduce reported net income but do not involve an actual outflow of cash in the current period. By excluding them, EBITDA aims to give a clearer view of the cash-generating ability of a company's core business before the effects of financing, taxes, and non-cash accounting. This makes it easier to compare the operational performance of different companies, especially those with varying capital structures or depreciation policies.

Limitations of EBITDA as a proxy for cash profit:

Despite its common use, EBITDA is not a direct measure of cash flow and has several critical limitations:

• Ignores Changes in Working Capital: EBITDA does not account for changes in working capital (current assets like accounts receivable and inventory, and current liabilities like accounts payable). Fluctuations in these items can significantly impact a company's actual cash flow. For example, an increase in accounts receivable means sales have been made but cash has not yet been collected, reducing actual cash available.
• Excludes Capital Expenditures (CapEx): While depreciation and amortization are non-cash, they represent the consumption of assets that eventually need to be replaced or maintained. EBITDA completely ignores the cash outflows required for capital expenditures, which are essential for a business's long-term survival and growth. A company with high EBITDA might still have low cash flow if it has substantial capital expenditure needs.
• Omits Interest Payments and Taxes: Interest payments on debt and income taxes are real cash outflows that a company must pay. EBITDA excludes these, which can be misleading, especially for highly leveraged companies or those with significant tax obligations.
• Not a GAAP/IFRS Metric: EBITDA is not a standardized metric under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). This lack of standardization means companies can calculate it differently, potentially manipulating the figure to present a more favorable financial picture.
• Does Not Reflect True Liquidity: A company can be profitable and have a high EBITDA but still face cash flow problems if it cannot collect its receivables, has high inventory, or significant debt servicing requirements.

In conclusion, while EBITDA can offer a quick snapshot of a company's operating profitability by removing certain non-cash and non-operating items, it is an incomplete and often misleading proxy for actual cash profit. For a comprehensive understanding of a company's liquidity and financial health, it is crucial to analyze the full cash flow statement, particularly cash flow from operations, and consider capital expenditures, interest, and taxes.