CFO and EBITDA?

[krokodilizm]

What is the connection here?

“If working capital is growing, EBITDA will overstate cash flows from operations”.

[cpk123]

discussed here already …

http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91333103

When you calculate CFO via the indirect method, you start, essentially, with EBITDA, then subtract the change in working capital. If working capital is growing, that change will be positive; by stopping at EBITDA, you don’t subtract that positive change.

Set a more clear example:

Working capital accounts are mainly receivables (CA), inventory (CA), payables (CL), short-term liabilities (CL). Note that short-term portion of long-term debt is not considered as a short-term liability in this case.

working capital = CA - CL, if WC is growing, then it is possitve, so CA is higher than CL.

Assume that CL has not changed and also inventories has not changed. The only account that has changed is receivables. When a company sales its goods or services, those sales can be exchanged for cash or credit. If the company sales on credit, receivables will increase. Because that sale was made that time, revenues account that sale despite it was made on credit. So here we have a first difference between revenues and cash flow.

Assume that receivables increased on $100, so revenues will increase on $100 and also EBITDA will increase on $100. Cash flow will increase $0 on that transaction.

If working capital increases systematically over time, EBITDA will be inflated in those working capital changes (assuming the other accounts don’t change). Thats why EBITDA can be used as a proxy of cash flows under certain assumptions or cases. Cash flow is always the best resource for valuation.

Hope this helped!