EBITDA overestimates cash flow from operations if working capital is growing.
FCFF = EBITDA (1-Tc) + Dep(Tc) - FCinv - WCinv FCFF = CFO + Int(1-Tc) - FCInv
How is that statement correct…?
Let’s say you use EBITDA as a proxy for CFO. Because CFO is already adjusted for working capital while EBITDA is not, the higher working capital the higher EBITDA compared to CFO, so the more EBITDA overestimates CFO.
These formulae do not help understand the intuition.
Like lunacy pointed out, EBITDA is sometimes used as a proxy for CFO (especially in Wall Street, so I read). That assumption is flawed in many ways, and one of the arguments against it is that EBITDA does not capture WC investments, whereas CFO does. So if you have a large WCinv CFO will be small but EBITDA is not affected in any way.
Don’t use FCFF to explain this, you may confuse yourself.
CFO = NI + Dep - WCInv
CFO = EBITDA(1-t) - Int(1-t) - Dep(t) - WCInv …(1)
Now quit WC investments from the calculation:
CFO = EBITDA(1-t) - Int(1-t) - Dep(t) …(2)
Which is higher (1) or (2)?
Obviously assume interest expense and depreciation are the same, so if WCInv is positive (growing, because WCInv is the change in WC account on balance sheet: Current assets - current liabilities), then EBITDA will overstimate CFO systematically: (1) > (2)
Very well explained, Sir Harrogath. 