Basic, lesson 1 of 3
The statements as a buyer reads them
A buyer prices on EBITDA but pays the debt with cash. This lesson walks from one to the other and names what EBITDA leaves out.
9 min, 3 checks
1Why EBITDA, and why it is not cash
Funds quote prices and leverage as multiples of EBITDA because it is close to the operating profit of the business before financing and accounting choices. Two companies with different debt, tax positions, and depreciation schedules can be compared on it.
The problem is that lenders get paid in cash, not EBITDA. Between the two sit four items that EBITDA ignores: capital expenditure, changes in working capital, cash taxes, and interest. A business can show rising EBITDA and still run out of cash if any of those grow faster.
| Item | Why EBITDA ignores it | Why a buyer cares |
|---|---|---|
| Capex | It is an investment, spread over years as D&A, which EBITDA adds back | It is cash out the door every year, and some of it is needed just to stand still |
| Working capital | Accrual accounting records sales and costs before cash moves | A growing business ties up cash in receivables and inventory |
| Cash taxes | EBITDA is pre-tax | Taxes are paid in cash before lenders and the fund |
| Interest | EBITDA is before financing | In an LBO, interest is often the biggest single use of cash |
Check 1
Which of these does EBITDA capture?
2The walk from EBITDA to cash
Cash available for debt service = EBITDA - capex - increase in net working capital - cash taxes
Subtract interest from this and what is left can repay principal or build cash.
Worked example
Harbor Pumps, one year, in $ millions
- 1EBITDA: 50
- 2Less capex of 12: 38
- 3Less the increase in net working capital of 4: 34
- 4Less cash taxes of 6: 28 of cash available for debt service
- 5Less interest of 10: 18 left to repay debt
Harbor turns 50 of EBITDA into 28 of cash before interest, a conversion of 56%, and only 18 can go to paying down principal.
Check 2
EBITDA is $80m, capex $20m, working capital rises by $5m, and cash taxes are $10m. What is cash available for debt service, in $m?
Check 3
In the Harbor example, what share of EBITDA became cash available for debt service, in percent?
3Net income is the wrong starting point
Net income mixes in non-cash charges (D&A, stock compensation, amortization of financing fees) and leaves out capex and working capital entirely. After an LBO it is often negative, because new interest and the D&A from purchase accounting push it down, while the business throws off plenty of cash.
Terms in this lesson: EBITDA, Depreciation, Capital expenditures, Accrual accounting, Leveraged buyout, Net working capital, Net income, Amortization.
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