There are many different ways to measure business profitability. Among these, two metrics often stand out and are frequently compared: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and Free Cash Flow (FCF). While both are used in the same business contexts, it is important to note that these metrics are not interchangeable.
EBITDA and FCF offer unique insights; EBITDA reflects a business’ operational efficiency and consequent profitability, whereas FCF illustrates the cash generation capability of a business after spending on key investments.
Depending on the use case, both metrics can be valuable. Understanding the basics of EBITDA vs Free Cash Flow will help you determine which may be more useful in evaluating business investments.
EBITDA: A Metric for Operational Insights
EBITDA is a measure of profitability that emphasizes core operating performance by excluding the effects of financing, taxation, and non-cash expenses like depreciation and amortization. For companies seeking to present a straightforward look at operational efficiency, EBITDA can serve as a valuable metric.
EBITDA Formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Note: Depreciation refers to the process of allocating the cost of a tangible asset (like a car) over its useful life. For example, a company that bought a car has a choice to not take the full cost of the car as a company expense only in the year it was purchased. Instead, the company can choose to spread the cost over the car’s useful life. This cost is recorded as a depreciation expense on the income statement. Amortization follows the same principle, except that it applies to intangible assets (such as patents or software).
The advantages of EBITDA include:
Debt Neutrality: By excluding interest, EBITDA allows for comparisons across businesses with different financing structures.
Tax Independence: Removing the influence of taxes creates a level playing field for comparison, regardless of location or tax strategy.
Operational Focus: EBITDA shines a light on the efficiency of core business activities, helping analysts gauge profitability without the noise of financial structuring.
However, EBITDA does have limitations. Because it excludes capital expenditures (CapEx), it can present an overly optimistic view of cash flow, especially in industries with high maintenance or replacement costs.
For instance, companies requiring significant reinvestment in assets may show strong EBITDA figures, but struggle with actual cash generation due to CapEx needs.
Free Cash Flow: A Metric for Business Outlook
Free Cash Flow (FCF) represents the cash generated after accounting for capital expenditures. This metric is essential for understanding a company’s available cash for activities like paying dividends, buying back shares, or reinvesting into business growth.
FCF Formula:
FCF = Operating Cash Flow − Capital Expenditures
Operating Cash Flow includes the cash generated from the company’s regular business operations. It is calculated by starting with net income, then adding back non-cash expenses (such as depreciation and amortization), and adjusting for changes in working capital.
You can find it on the company’s cash flow statement, typically under “cash flows from operating activities.
Capital Expenditures (CapEx) are funds used to acquire, upgrade, or maintain physical assets such as buildings, technology, or equipment.
The key advantages of FCF include:
Long-Term Viability: By accounting for necessary investments, FCF provides a realistic view of cash availability and sustainability.
Liquidity Insight: FCF is often a strong indicator of financial flexibility, showing whether a company has the means to fund growth or manage unforeseen expenses.
Debt Repayment and Expansion: FCF gives investors insight into whether the company can meet its obligations, reinvest, or pursue expansion without risking cash flow stability.
However, FCF can be subject to variability depending on individual investment decisions. Companies with heavy upfront investments in assets may show low FCF initially, even if their long-term profitability is strong. Additionally, unlike EBITDA, which offers immediate operational insights, FCF may not provide a quick performance snapshot, as it is heavily influenced by CapEx timing.
EBITDA vs Free Cash Flow - Key Differences
and Use Cases
Short-Term vs. Long-Term View
EBITDA gives a snapshot of operational efficiency by focusing on core profitability, excluding non-operating expenses like taxes and depreciation. This makes it ideal for evaluating a company’s short-term performance. In contrast, FCF provides a longer-term view by factoring in capital expenditures, showing how much cash remains after necessary investments for business growth or debt repayment.
Focus and Use
EBITDA is primarily used to assess operational efficiency, making it useful for comparing companies’ profitability regardless of their capital structure. FCF, however, reflects a company’s actual cash flow after reinvestment needs, giving a better indication of long-term financial health and liquidity.
Impact of Capital Expenditures
EBITDA excludes capital expenditures, which can make it appear more profitable, especially in asset-heavy industries. FCF, however, accounts for these expenditures, offering a more realistic view of cash available for reinvestment, dividends, or debt reduction.
Investor Relevance
EBITDA is helpful for investors focused on short-term profitability and operational performance. FCF is more relevant for those interested in the company’s ability to sustain long-term operations, growth, and cash flow stability.
EBITDA measures the earnings before taking account of taxes, loan interest, and other essential expenses, while FCF measures a company's unencumbered cash flow at the end of the year.
It's important to determine which metric between EBITDA vs Free Cash Flow will be most useful to you, as a potential investor, and what sort of financial insight you’ll need.
EBITDA and FCF Aren’t Directly Comparable (Numerically)
Something to note is that EBITDA and FCF are not directly comparable, at least numerically, due to their differences in components and implied accounting methods.
For one, you’ll need to gather data from your income statement to calculate your EBITDA, while the cash flow statement is the starting point for FCF-relevant figures such as the operating cash flow.
This different source in financial statements is stemmed from the fact that EBITDA and FCF relies on different accounting methods:
EBITDA follows accrual accounting, which records income and expenses when they occur rather than when cash exchanges hands. This approach smooths out financials but may obscure cash flow reality.
For example, depreciation spreads the expense of assets like vehicles over their useful lives, offering a stable measure on the income statement even though no cash outflow occurs each year.
On the other hand, FCF uses cash accounting, which only records cash when it is received or paid out, giving a clearer view of actual cash flow.
For example, while a business might show a consistent EBITDA figure by spreading asset costs, its FCF would reflect large cash outflows for assets as they are purchased, which can reveal the actual cash demands of the business.
Accrual Accounting | Cash Accounting | |
Revenue | Earned | Received |
Expenses | Incurred | Paid |
Key Business Scenarios and What They Mean
These scenarios help clarify the importance of considering both metrics for a comprehensive view of financial health.
High EBITDA, Low FCF
This scenario often occurs in businesses with significant CapEx, especially in asset-heavy industries (e.g., manufacturing, telecommunications). High EBITDA suggests strong core profitability, but low FCF indicates that a large portion of cash is required for reinvestment in assets.
While operationally profitable, the business may have limited liquidity and financial flexibility due to heavy investment needs. This could signal potential cash flow constraints for future growth or debt repayment if CapEx continues to be substantial.
Low EBITDA, High FCF
This can happen in industries with low ongoing CapEx requirements or in businesses that recently completed large capital investments. Low EBITDA suggests limited profitability at the operational level, but high FCF indicates strong cash flow availability, potentially from reduced CapEx or efficient working capital management.
Although core profitability is weak, the business has liquidity and may have cash available for debt reduction, dividends, or reinvestment, often signaling strong cash management or minimal reinvestment needs in the near term.
Choosing between EBITDA vs Free Cash Flow (FCF) depends on the specific insights you seek about a business's performance.
EBITDA provides a snapshot of operational efficiency, stripping out variables like financing and tax, making it useful for comparing core profitability across companies.
In contrast, FCF gives a clearer picture of cash availability by factoring in capital expenditures, helping assess long-term financial stability and growth potential.
Both metrics, when used together, offer a balanced view, allowing investors and analysts to understand a company’s immediate profitability as well as its ability to sustain and invest in future growth.
Why We Use EBITDA
Who wants to get controversial? In this blog, Ashley dives into the basics of how to determine how successful a business is based on its metrics, which, surprise, are not always the same.
When it comes to valuing these linehaul businesses, I've seen it done in many ways. 1X revenue + the value of the trucks was sold to me once. Recently, however, a trend has emerged among the linehaul leadership and minds I respect most. Based on my social media postings, you can probably guess who some of those people are.
What makes FedEx Linehaul unique in business valuation is the FedEx contract—the relationship with FedEx Ground that everyone wants, with all its pros and cons. That's where the value comes from, and that can be a challenging conversation to have with someone who is an experienced small business owner.
Over the years, I've bought linehaul runs that were generating zero revenue because they weren’t running. Sometimes, the contractor didn’t have a truck or couldn’t find a driver or team, yet I still bought the run because I value the contract with FedEx. I trust what FedEx says the run will do, not what the contractor has done over the past three years.
When it comes to expenses, I know what they should be, even if they’re not currently “accurate.” A contractor who is in over their head and desperate to sell will be running the business less than optimally. Once I own the business, I’ll adjust those expenses to reflect what they should be. The trucks I choose, how I depreciate them, and the taxes flowing to me personally from my S Corp are unique to my operation. Your free cash flow doesn’t matter to me because mine will be different—I’ll run my business differently than you.
One point I try to stress to our clients is that we’re not buying a business; we’re buying a collection of routes contracted to FedEx Ground. Obviously, we do want to verify run information from the contractor and get a good sense of how the route has been operating recently, but the most valuable info I get comes from the station during the LIM.
If I’m being honest, half the people I talk to think I’m insane and never reach out again. A few years ago, this felt isolating since no one else seemed to think this way. But recently, I’ve realized I’m not alone in valuing businesses like this.
In conclusion, when it comes to FedEx Linehaul runs, the FedEx contract—what FedEx projects the run will do and verifies it’s doing—is far more critical than what the contractor has done over the past three years. How many people got hoodwinked into buying URR Teams doing a “guaranteed” 6K miles from late 2020 to early 2023? In my humble opinion, our way is better... And I will miss the half of you that unsubscribe due to my lunacy.
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