Geoff Gannon Investor Questions Podcast #4: What is the Difference Between Earnings, Free Cash Flow, and EBITDA?

The word EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation & Amortization.


So the relationship between EBITDA and earnings is exactly what it sounds like. EBITDA equals earnings plus interest, taxes, depreciation, and amortization. Those are all expenses. So you add those 4 things back to earnings and you have EBITDA.







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There are 2 big differences between free cash flow and EBITDA. Free cash flow includes changes in working capital. EBITDA does not. And free cash flow is reduced by capital spending. EBITDA is not.


Now I’m going to get a little technical here. Because we need to talk about working capital. When I say working capital I mean current assets that aren’t cash.


If you look at a balance sheet from an American company you’ll see current assets at the top of the page. The assets are listed in order of liquidity. And by liquidity we mean how fast and how easy it is to turn those assets into cash.


Every balance sheet is different. But there will be at least 4 current assets listed on most of them. Those 4 assets are:


#1: Cash - usually called cash and equivalents.


#2: Receivables - sometimes called accounts receivable.


#3: Inventory


And #4: Prepaid expenses - sometimes just called “other current assets”.


Not all businesses have inventories. But almost all businesses have receivables.


So what are receivables? And why should you care about them?


The easiest way to explain receivables is to use an example.


Let’s say you run a website like I do. And let’s say you put Google Ads on that website. Google Ads are those annoying little white boxes on the sides of websites. They’re context based. So if you’re on an investing site you see ads for discount brokers. And if you’re on a tech site you see ads for wireless routers.


The company paying for the ad is billed every time somebody clicks the ad. And the website owner earns money with each click.


But here’s where receivables come in. It’s not practical for Google to demand the advertiser send cash the instant the ad is clicked. And it’s not practical for Google to send cash to the website owner every time the ad is clicked. Neither of those things make sense.


Everybody would need to know each other’s bank accounts. And they’d spend most of the day sending a few cents back and forth.


It would be a waste of time. And money. And it would drive customers crazy. Customers Google wants to keep doing business with.


So instead everybody extends each other credit. Which really means they give each other time to pay. Google sends one bill a month to the advertiser. And one check a month to the website owner.


Everybody’s happy.


Unless you need cash. If you’ve never been self-employed you’ve probably never had to worry about receivables. But the moment you go into business for yourself you start to care a lot about receivables.


Because - like I said - if you own the website and someone clicks that ad - you earn the money the moment the ad is clicked. But those earnings won’t pay your bills. You can’t take the money Google owes you to the supermarket and buy food next week. You have to wait till the monthly check comes in. And if you’re dealing with customers who aren’t as quick to pay - then you start to care a whole lot about receivables.


Because instead of using the debit card at the supermarket you have to use a credit card. Yeah - you earned the money - but the cash isn’t in the bank yet. So you have to get it from somewhere else. Like a credit card.


And that’s what happens to businesses big and small. Their customers owe them money. And they owe their suppliers money. Sometime in the next 30 days or 90 days or whatever’s the tradition in that industry - all your customers will pay you and you’ll pay all your suppliers. But every day you’ll be starting the cycle over with a new customer and a new supplier. Or at least with new orders.


Remember when I talked about float? I said that because an insurance company takes in premiums before it pays out claims - as long as an insurance company is growing it will have extra cash on hand. That cash hasn’t been earned. Because it’s a future expense. It will be paid out some day. But it will also be replaced with new premiums. So the total amount of float stays the same. And that float can be used like an asset. Even though it’s really a liability.


If you’re still confused about float - go to BerkshireHathaway.com and read Buffett’s latest shareholder letter. He explains float in a couple sentences. And says pretty much what I did. As long as an insurance company grows - its float doesn’t run out.


The same thing is true of receivables. As well as inventories and prepaid expenses. But let’s stick to receivables for now. If a customer who owes you pays 30 days from today you only get rid of that receivable. You don’t actually end up with lower total receivables on your balance sheet unless you sell less stuff on credit. And since most businesses don’t suddenly demand cash from their customers - the only way you end up with lower receivables is if you have lower sales. In other words business slows down.


Kind of. There’s actually another way to end up with lower receivables and more cash every day. All you have to do is get your customers to pay their bills faster while paying your own bills slower. Any combination of those two things will give you more cash in your pocket. Your earnings don’t go up. And your sales don’t go up. You just move the cash from your customer’s pocket into yours.


Some people get this right away. Others think it’s some kind of brain teaser. I hope it’s easy for you. But if you’ve never taken an accounting course - or run your own business- you may think I’m talking about smoke and mirrors.


I mean - if your earnings and sales don’t go up - is the cash you get really worth anything?


The answer is yes. Having cash is always better than not having cash. You can earn interest on it instead of paying interest on it. And you can grow your business faster without depending on lenders. Everything is easier with cash. And everything is harder with credit.


The important thing to remember is that free cash flow includes changes in things like receivables. Earnings and EBITDA do not. If a company’s customers pay their bills slower this year than they did last year - that company’s free cash flow goes down. Even if earnings and EBITDA don’t. If a company pays its bills faster - free cash flow drops then too. And the opposite is true. If a company’s customers pay faster and the company pays slower - the company’s free cash flow goes up. Even if earnings and EBITDA don’t.


I hate to say this. But the best way to understand the difference between earnings, EBITDA, and free cash flow isn’t listening to me talk about it. The best way - and the easiest way - is to go to EDGAR and look up a few 10-Ks. Print out the balance sheet, income statement, and statement of cash flows. Then spread them out on your office desk or your kitchen table or wherever you can see them all at once.


That’s the best way to learn the difference between earnings, EBITDA, and free cash flow. Because you can go through the statements - line by line - with a calculator or a pen and paper and check that what I’m saying - and what you’re thinking - is true.


This is easier to do on paper than it sounds. Because the accountants who create the cash flow statement use something called the indirect method.


Think back to high school algebra. Because that’s what accountants do when they create the cash flow statement. They don’t actually count the cash when it comes in and goes out. Instead they just work backwards from the income statement. They add back the non-cash charges and then they take the flip side of the changes in current assets other than cash.


Think back to the receivables example. You don’t need to be a professional accountant to be a good investor. But you should know the big ideas in accounting. And one of the biggest is the idea of double-entry bookkeeping.


Double entry bookkeeping means that every event has to hit two accounts at the same time. So when someone clicks that Google Ad the accountant doesn’t just add a dollar to sales. He adds a dollar to sales and adds a dollar to receivables. And then later when that receivable is paid - he has to change two accounts at the same time. But this time he doesn’t touch the sales account. He just takes one dollar from receivables and puts that dollar into cash.


That brings us to the second big idea in accounting. The first big idea is double-entry bookkeeping. The second big idea is called the matching principle.


Accountants match income and expenses against each other. Things happen over time. But balance sheets only show you a moment in time. And income statements and cash flow statements only show you 3 months at a time or 1 year at a time.


Some things are always half done on any given day. So accountants try to match the stuff you give up with the stuff you get.


Let’s say you buy an apple tree and plant it in your yard. Over the next year you care for it. You buy fertilizer. And insecticide. And you hire a worker to go out and prune the tree. And then - one day - you pick the apples.


If we only looked at that last day we’d just see the income. And we wouldn’t see any of the expenses. Even if we looked back 3 months or 6 months ago when you hired the worker and fertilized the tree and all that - we wouldn’t see all the expenses.


So what we have to do is take the price of the apple tree. And instead of counting the whole amount on that first day. We spread it out over the life of that tree. We take the cost and we try to match those apples to that tree. Even if that means we have to count apples that grow 1 or 2 or 6 years after you bought that tree. Because in a sense the apples are what you get for buying the tree in the first place.


So on an income statement we spread the cost of the tree out for as long as we pick apples. We’re trying to match sales and expenses.


I’m simplifying things here. But I just want to explain why the cash flow statement and income statement are different.


Cash is important. But cash flows are uneven. You can spend a lot of cash up front and then nothing for years and years. That apple tree may not take much work in year 5 or 6. But if the tree itself cost a lot to buy - those are expensive apples.


Alright. Enough analogies. Let’s get back to the cash flow statement. Just read it. And you’ll understand it. The most important thing is to look at the balance sheet and income statement at the same time. That way you can see that the stuff listed on the cash flow statement like changes in working capital are coming from the balance sheet. That’s where you get the numbers from.


The statement of cash flows starts with earnings. And then it adds all this other stuff.


This is kind of an obvious point. But I’ll make it anyway. The numbers listed on the cash flow statement below the net income line are the reverse of what actually happened to those items.


If you see an accounts receivable number in parentheses - which is a negative number - that actually means accounts receivable went up. And cash went down. You’re taking the flip side of the change in accounts receivable because we’re working backwards to get the change in cash.


Again - this sounds more complicated in a podcast than it is on paper. If you have the 3 statements in front of you it all becomes a clearer.


That’s right. Most companies don’t have big differences between free cash flow and earnings over a long time. In any one year they might. But over time they tend to be similar. And the difference is more constant than you’d expect. It’s not random. It has to do with the nature of the business. And the timing of cash flows.


For example: every publicly traded North American railroad reports earnings that are much higher than free cash flow. If you look at the last 15-20 years for each of them - I would guess that no railroad had free cash flow equal to more than 50% of its earnings.


Railroad earnings are overstated. Advertising agency earnings are usually understated. If an ad agency is growing year in and year out for two decades - it’s going to keep having free cash flow higher than earnings. Ad agencies are the opposite kind of business from railroads. They get more cash as they grow. Railroads invest more cash as they grow.


An average business - one that’s not extreme like a railroad or an ad agency - will have free cash flow close to but not as high as earnings. Something like 90 cents of free cash flow for every dollar of earnings is normal at a lot of businesses.


If you’re worried that something doesn’t add up when you’re looking at a stock’s free cash flow and earnings per share - look back at the last 10-20 years. Has the ratio between the two numbers changed? Or is it pretty much the same?


If there’s been a change - you should try to find where that change is coming from. Again - that’s easy if you lay the income statement, cash flow statement, and balance sheet on a table and look back and forth from one statement to the next.


Buffett’s talked about free cash flow a lot. In his 1986 letter to Berkshire Hathaway (BRK.B, Financial) shareholders he used the purchase of Scott Fetzer to illustrate what he calls “owner earnings”. Which are a lot like free cash flow. Buffett even talks about making sure you include changes in working capital.


Buffett’s “owner earnings” number is usually going to be higher than EBITDA. But lower than free cash flow. He tries to separate capital spending meant to grow the business from capital spending meant to maintain the business.


Buffett is right to do that. And I’d also try to back out capital spending used to grow the business - if I was looking at a stock on my own. But when talking about a stock on the podcast - it’s hard to do that because it doesn’t give me an exact number to share with you. And it’s always easier for listeners to follow along if I’m using data from the 10-K that we can all agree on.


Most companies don’t split the capital spending line into two parts: one for spending used to keep up the business and one for spending used to grow the business. A few do. But it’s rare. Retailers can do this better than manufacturers. That’s because retailers often grow by building new stores instead of adding on to old stores. So you can find the cash spent to open new stores - which they’ll often tell you in the 10-K or on a conference call. And then you add that back to free cash flow.


For other businesses it’s too hard to get an exact “owner earnings” number. But you can guess by looking at how much everybody in the industry spends.


For example: I’d say a railroad has to spend about 6% of its assets each year to keep its competitive position. The number could be a bit lower. But not a lot lower.


No one is going to tell you railroads spend 6% of their assets to keep up the business. You just have to look at the 10-ks for the railroads going back 10-15 years and that’s the number you come up with.


You can do the same thing with any industry. If you think it’s that important. It usually isn’t. Railroads are about as asset heavy a business as you’ll ever see.


If you stick to asset light businesses - you don’t have to spend much time thinking about capital spending.


Okay. Those are really separate issues. The reason lenders use EBITDA when looking at a business has to do with tax laws. The interest on a company’s debt is tax deductible. So you have to use earnings before interest and taxes. Because the more debt you have - the more interest you pay. And the more interest you pay - the less taxes you owe.


Leveraged buyouts are done in part because of tax laws. If a company finances itself with a lot of bonds and very little stock it can pay less to the government and have more cash to give the people financing the business. The only catch is that the people financing the business have to be bond holders instead of stock holders.


The reason media companies were valued on EBITDA is completely different. And here we’re going to get into more accounting than I want to. But it’s the only way to explain this.


The word “goodwill” when you see it on a company’s balance sheet does not mean what you think it means. Accounting goodwill is not the same as economic goodwill. So we can say that Google (GOOG, Financial) has a lot of economic goodwill because of all the successful searches people do there. The memory of those searches makes people think of Google first whenever they do a search. It becomes a habit. And habits are hard to break.


Google built up that goodwill itself. So it doesn’t put anything on the balance sheet.


But if some other company bought Google it would have to pay a lot more than book value. And whenever a buyer pays more than book value they put the extra amount paid into a line called “goodwill”.


So on a balance sheet - goodwill is just another way of saying “price paid above book value”.


Companies used to amortize that kind of goodwill. That means they took a piece of the goodwill off their balance sheet every year and took an equal dollar amount out of reported earnings.


The rules changed. And they don’t have to do that anymore. Instead companies can keep the goodwill on their balance sheets forever the same way they keep land on their balances sheet forever.


That’s why media companies were valued using EBITDA. Yes - you could load them up with debt. But it was more than that. Reported earnings had nothing to do with economic earnings. Because media companies were buying each other left and right. And a lot of their so called expenses were just the amortization of acquired goodwill. Which is a nonsense expense that modern accounting has done away with.


Then you mentioned EBITDA and bubbles. The reason for that is simple. People use EBITDA instead of earnings in bubble times because EBITDA is always higher than earnings. So if you just slap the same multiple on a higher number you can argue for higher prices. And in a bubble people want to buy stocks. Using EBITDA makes irrational exuberance sound more rational. That’s why you hear more about EBITDA during a bubble.


It’s good as long as it stays that way. If a growing company always has free cash flow that’s higher than earnings and it can keep growing - then it’s a good thing. Sometimes - and I don’t want to get into this because it’s rare - a company’s free cash flow is higher than its earnings because the company is shrinking.


Like I said - it’s rare. And it’s not worth talking about except in special situations like when Warren Buffett took over Berkshire Hathaway. He milked the textile business for cash and then put that cash into other things. The way you do that is you don’t try to grow sales you just try to turn inventories and receivables into cash faster and faster. It doesn’t last forever. And it will almost never come up in your investing career.


What we’re usually talking about is growing companies that always seem to have free cash flow that’s higher than earnings. And in that case the answer is yes. It’s always a good thing.


You can skimp on capital spending. That’s about it. All the other tricks to jack up free cash flow in the short term but harm the business in the long term can also be used to jack up short term earnings and EBITDA.


The oldest tricks in the book are raising prices and cutting advertising. But - again - those changes would affect earnings, EBITDA, and free cash flow. Not just free cash flow. The only special trick for raising free cash flow is lowering capital spending.


Railroads and utilities can - and have - done that when they needed to pay off creditors. You sometimes notice a pattern where the lowest capital spending is at companies with bad balance sheets during a credit crisis. The reason is obvious. They don’t want to end up in bankruptcy. They know they’re hurting the business. But they have to pay off their loans.


As far as your concern that a company would manipulate free cash flow - I wouldn’t worry about that. The media focuses on earnings. And it’s harder to fudge free cash flow because the company on the other side - the customer or the supplier or whoever it is - has to be willing to part with the cash. Earnings are easier to play with in a way that makes one party look better without making the counterparty look worse.


Having said that - you should trust your gut. You asked a lot of questions about a specific company - Affiliated Managers Group (AMG, Financial). And I get the feeling you aren’t totally comfortable with the company or the management.


You picked a hard to understand company. It’s a serial acquirer with a lot of deals accounted for in different ways. It has consolidated and unconsolidated holdings. Some are carried as marketable securities. Others use the equity method. Most don’t require amortizing goodwill. But a couple do because they weren’t structured as acquisitions of companies but as acquisitions of contracts. A lot of the acquisitions are revenue sharing agreements. But not all of them. There are profit sharing agreements in there too. Which means the company shares the expenses at some of its affiliates.


AMG has convertible securities. That makes figuring out share dilution much harder. It also did a couple derivatives deals that were small but seemed kind of unnecessary to me.


That’s probably an unfair criticism. But you asked me to take a look at this particular company. I did. And I think it’s a lot more complicated than most.


What’s bothering you is that you can’t wrap your head around the business in a way that makes you feel comfortable. So my advice is: don’t buy the stock.


Even if it’s a great stock. It’s not for you. When in doubt - apply this test: imagine you already own the stock and then it drops 15% in a day and there’s some bad news o some bad rumors - how would you feel then? Would your stomach start to churn? Would doubts creep in? If you owned Berkshire Hathaway I think you’d feel fine.


Now I don’t think Berkshire Hathaway is cheap. And I don’t think you should buy it. But I do think you need to stick to stocks you feel comfortable owning.


And I don’t think Affiliated Managers Group is the right stock for you. I think if you bought it and times got tough - you might not make the best decisions.


I hope I answered your questions about free cash flow. But I also hope you try to look for simpler stocks. Companies you can feel comfortable owning. Don’t make investing harder than it has to be.


You don’t have to have an opinion about Affiliated Managers Group.


You just need to find the right stock for you. And while you may be able to understand Affiliated Managers Group well enough to read the financial statements. I don’t think you’ll ever understand it well enough to buy the stock.


Okay. That’s all for today’s show. If you have an investing question you’d like answered call 1-800-604-1929 and leave us a voice mail. That’s 1-800-604-1929.


Thanks for listening.