In the midst of all the scrutiny over company financial statements these days, it behooves us to revisit every money-losing company's favorite acronym, EBITDA, or earnings before interest, taxes, depreciation, and amortization.

So, what is EBITDA, anyway? Is it a valuable measure of cash flow, shenanigans to make unprofitable or marginally profitable companies look sharp, or something in between? Our take is that it's more of the latter, with fairly limited usefulness.

Many publicly traded companies tend to refer to EBITDA as though it represents "cash" earnings, based in part on the fact that the "D" and "A" in EBITDA are non-cash expenses. Nevertheless, it's not the same as real operating cash flow.

Let's start with the party line on EBITDA: Capital-intensive companies report EBITDA to give investors a feel for cash flow before debt payments, taxes, depreciation, and amortization charges reduce the income statement to ashes.

Uses of EBITDA
First we need an example of what EBITDA does, because it can be handy. Say you're six years old and want to open an orange-aid stand, hoping you'll grow huge enough one day that Coca-Cola(NYSE: KO) will buy out your operation rather than take on your competitive threat. You have no money, so mom and dad front the capital equipment costs: $30 for oranges, cups, sugar, water, and signage (not signs, signage).

At the end of the day, mom and dad want to know how much money you made. They don't want a figure that's been adjusted for interest payments on the debt you owe them, taxes, and depreciation of the fixed assets -- unless they're accountants who need some time away from work. That's the idea behind EBITDA -- to give investors a sense of how much money a young or fast-growing company is generating before it shells it all out to creditors, Uncle Sam, etc. If EBITDA grows over time, it gives investors at least some sense of future potential profitability, which is why some investors look at "EBITDA margin" as a substitute for net margins.

A couple of problems
Nevertheless, there are two problems: First, EBITDA leaves out so many expenses that to think of it as a measure of profitability is a huge mistake. Second, it's not a proxy for cash flow, since it doesn't measure actual cash flowing into a company.

Specifically, EBITDA neglects the following considerations:

  • Variations in accounting methods
  • Cash required for working capital
  • Debt payments and other fixed expenses
  • Capital expenditures

Capital expenditures, for example, are a critical, ongoing outlay for almost every company. But since capital expenditures aren't part of the EBITDA mix, it's worse than useless for investors to start basing a company's valuation on it.

EBITDA also falls short as a measure of cash flow -- which makes it especially confusing, since companies often use the terms interchangeably. EBITDA doesn't really measure cash flow at all, since it neglects the balance sheet.

Other ways to measure cash flow
Is there a better way to evaluate cash flow? Sure, just look at cash flow from operations. If you want to go a step further, look at free cash flow (FCF). In its simplest form, FCF is simply cash from operations, minus capital expenditures. This has the advantage of capturing at least three items EBITDA leaves out: receivables, inventory, and capital expenditures (property, plant, and equipment).

Free cash flow is certainly not a cure-all, since it omits the cost of debt. Also, keep in mind that many terrific companies are cash-flow negative in their formative stages. Wal-Mart(NYSE: WMT) reported negative free cash flow for years, while handily beating its cost of capital and building its retail empire. Focusing on FCF alone could lead investors to miss opportunities.