Cash Flow From Operations vs EBITDA: Why the Proxy Leaks

Earnings before interest, tax, depreciation and amortisation (EBITDA) is what the trading earned before those four charges. Cash flow from operations is the money the running of the business actually put into the bank. Between the two sit the movement in the working capital balances, the tax genuinely paid, and any non-cash charge EBITDA has not already removed. EBITDA is used as a stand-in because it strips the largest non-cash charge, and it leaks worst where cash matters most.

The comparison rests on a difference of ambition. EBITDAEarnings before interest, taxes, depreciation and amortisation. A subtotal of what the trading of a period earned. Those four charges are not yet taken off. removes one large non-cash chargeAn expense recorded in the accounts for which no money left the business during the period. The money either left in an earlier period or has not left yet. and then stops. Cash flow from operations removes every non-cash item it can find, and then goes further and asks a question EBITDA never asks: of the money the accounts say was earned, how much actually arrived, and of the money the accounts say was owed, how much actually went out. The distance between the two figures is simply everything EBITDA declined to look at.

Take a case with no accounting in it at all. A wedding caterer works a three hundred guest reception in November. The food was bought, the cooks were paid, the tempo van was hired, and at the end of the night the caterer has earned, quite properly, a profit of Rs 80,000/- on that one job. The Rs 80,000/- is real and it is not a trick. But the client is a hall that settles in sixty days, the vegetable supplier wants his money on Friday, and the deposit for the December bookings has to be paid next week. In November the caterer has earned Rs 80,000/- and has minus Rs 40,000/- in the bank. Nothing has been misstated. Earning and receiving are two different events, and everything that separates EBITDA from operating cash flow lives in the space between them.

The worked case throughout is Anjani Stationers, an invented notebook printer, in its second year. Revenue Rs 2,70,00,000, EBITDA Rs 53,50,000, and net cash from operating activities of Rs 36,30,000.

What is EBITDA when the question is about cash?

EBITDA is earnings before interest, taxes, depreciation and amortisation. Read for this comparison, the useful way to hold it is as a figure built entirely out of the statement of profit and loss, using the accounting idea of when a sale counts and when a cost counts, and never once asking when money moved. A sale to the Sunrise Public School group in March counts in March whether the school pays in March, in June, or not at all. A bill from the paper supplier counts when the paper is consumed, whether the supplier is paid on the day or in ninety days.

For Anjani Stationers, EBITDA of Rs 53,50,000 is revenue of Rs 2,70,00,000 less cost of materials consumed of Rs 1,48,50,000, employee cost of Rs 42,00,000 and other operating expenses of Rs 26,00,000. Rs 2,16,50,000 of cost is already inside the figure. So EBITDA is not a figure taken before costs. EBITDA is a figure taken before four named charges, and two of those four, depreciation and amortisation, are the reason anybody ever reaches for it when they want to talk about cash.

EBITDA answers what the trading of the year earned, measured on the accounting rule about when a sale counts, and it contains no information whatsoever about when money moved. That is not a criticism of the measure. The measure was built to do exactly that, and the trouble starts only when it is asked to do something else.

What is cash flow from operations when the question is about EBITDA?

Cash flow from operations is the net amount of money that the running of the business, as distinct from buying assets or dealing with funders, put into or took out of the bank during the year. The figure is not an opinion and it is not an estimate. Adding up every rupee that came in from customers and taking away every rupee paid to suppliers, staff and the tax authority arrives at the same figure by a longer road. For Anjani Stationers in year two that figure is Rs 36,30,000.

Almost every published statement builds it a shorter way, called the indirect methodA way of presenting cash from operations that starts with the profit figure and adjusts it, rather than listing every receipt and payment. Both routes reach the same number.. The indirect method starts from the profit figure and undoes everything in it that was not cash. The undoing is why an operating cash flow section looks like a list of add-backs rather than a list of receipts. The list reaches the same destination from the other side. Anjani Stationers' section starts at profit before tax of Rs 38,00,000, adds back depreciation and amortisation of Rs 12,00,000, adds back a provision for doubtful debtsAn amount set aside in the accounts against customer bills the business now doubts it will collect. The bill stays on the books; an offsetting allowance is recorded against it. of Rs 6,00,000, adds back the finance cost of Rs 3,50,000 because interest is shown further down, subtracts a net Rs 17,00,000 for the movement in the working capital balances, and subtracts Rs 6,20,000 of tax actually paid.

Cash flow from operations answers what the running of the business did to the bank balance, and it is the only figure on any statement that cannot be moved by an estimate. That property is what makes it the right thing to check EBITDA against, and it is also why the two figures so rarely agree.

What exactly sits between the two figures?

Three items, and they close the distance exactly. The bridge starts at EBITDA of Rs 53,50,000. The Rs 6,00,000 provision for doubtful debts sits inside the Rs 26,00,000 of other operating expenses and no money left the business for it. Adding it back reaches Rs 59,50,000. Taking off the net Rs 17,00,000 that the working capitalThe short term balances a business carries while it trades: what customers owe it, what it holds in stock, and what it owes suppliers. Money sits inside these balances rather than in the bank. balances absorbed reaches Rs 42,50,000. Taking off the Rs 6,20,000 of tax actually paid lands on Rs 36,30,000.

A bridge that can be walked in only one direction has not been understood. The same distance therefore runs the other way as a check. The gap is Rs 17,20,000. The working capital movement took Rs 17,00,000 and the tax paid took Rs 6,20,000, a total of Rs 23,20,000 out. The provision put Rs 6,00,000 back in. Rs 23,20,000 less Rs 6,00,000 is Rs 17,20,000. The whole distance between Anjani Stationers' EBITDA and its operating cash flow is three items, and the three items reconcile to the last rupee in both directions.

What is actually inside that working capital line?

Four balances moved, and the line on the statement is only their net. The net figure hides the fact that two of them worked against Anjani Stationers and two worked for it. Take them one at a time. Trade receivablesThe money customers already owe the business for goods delivered or work done, sitting on the balance sheet until it is collected. before any provision rose from Rs 78,00,000 to Rs 95,00,000, a rise of Rs 17,00,000. The rise is Rs 17,00,000 of sales counted in the year and standing unpaid at the end of it. Inventory rose from Rs 19,00,000 to Rs 28,00,000, a rise of Rs 9,00,000. The rise is Rs 9,00,000 of paper and board bought and still sitting in the godown. Receivables and inventory together took Rs 26,00,000 off the table.

Two balances pushed the other way. Trade payables rose from Rs 15,00,000 to Rs 22,00,000, so Anjani Stationers is holding Rs 7,00,000 more of its suppliers' money at the end of the year than at the start, and money not yet paid out is money still in the bank. The contract liabilityMoney a customer has already paid for goods or work the business has not yet delivered. The cash is in hand but the sale has not been counted yet. rose from Rs 2,00,000 to Rs 4,00,000. The rise is Rs 2,00,000 of school money collected in advance for notebooks not yet delivered. Payables and the contract liability put Rs 9,00,000 back. Rs 26,00,000 out against Rs 9,00,000 in leaves the net Rs 17,00,000 the statement shows.

The year one inventory of Rs 19,00,000 and the year one trade payables of Rs 15,00,000 are an assumed split of a single reported total, so the Rs 9,00,000 and Rs 7,00,000 movements built on them are assumed too. The working capital line is not one number but four, and reading only the net figure hides the fact that Anjani Stationers' customers and its godown absorbed Rs 26,00,000 while its suppliers and its advance-paying schools returned only Rs 9,00,000.

Why is the provision added back while the tax is taken off?

Because one of them moved money and the other did not, and that is the only test the bridge applies. The provision for doubtful debts went from Rs 3,00,000 to Rs 9,00,000, so Rs 6,00,000 was charged against the year's profit. Nobody received that Rs 6,00,000. No cheque was written, no supplier was paid, no bank account moved. The charge is the accounts recording a doubt about bills still on the books, and a doubt is not a payment. Because the charge sits inside the Rs 26,00,000 of other operating expenses, EBITDA is already after it, so the bridge has to put it back.

Notice what that add-back does not mean. Adding the provision back does not say the money will be collected. The add-back says the opposite: the receivables are looking worse, the accounts have recognised it, and the cash flow statement is simply declining to treat a recognition as a payment. A reader who sees a large add-back for provisions and reads it as good news has read the sign backwards.

The tax is the mirror case. The statement of profit and loss charged Rs 8,00,000 of tax. Only Rs 6,20,000 of that was current tax and left the business as money; the other Rs 1,80,000 is deferred taxTax recognised in the accounts now because of a timing difference between the accounting profit and the taxable profit, and not paid to the tax authority in the current year., recognised because of a timing difference and not paid to anybody this year. EBITDA is measured before tax altogether. The bridge therefore takes off the amount that genuinely left, Rs 6,20,000 and not Rs 8,00,000. The bridge adds back what was charged but never paid and subtracts what was paid, and it applies that single test to every line. The single test is why the Rs 6,00,000 provision goes in and the Rs 1,80,000 of deferred tax stays out.

Why do depreciation and interest never appear in this bridge?

The absence of depreciation is the trap that catches readers who learned the operating cash flow section first. In a published statement the depreciation and amortisation of Rs 12,00,000 is the biggest add-back of all, and the finance cost of Rs 3,50,000 is added back too. Neither of them appears anywhere in the bridge above. The absence looks like an omission and it is not.

The reason is the starting point. A published statement starts from profit before tax of Rs 38,00,000, a figure taken after depreciation and after interest. Both therefore have to be put back. The bridge above starts from EBITDA, and EBITDA is a figure taken before depreciation, before amortisation and before interest, so both are already outside it. The arithmetic closes: profit before tax of Rs 38,00,000 plus Rs 12,00,000 of depreciation and amortisation plus Rs 3,50,000 of finance cost is Rs 53,50,000, EBITDA exactly. Adding the provision of Rs 6,00,000 gives the Rs 59,50,000 that the published statement calls operating profit before working capital changes. The two routes are the same road walked from different milestones.

Interest carries one extra wrinkle worth naming. Anjani Stationers' Rs 3,50,000 of interest paid is shown under financing rather than operating. The placement is one of the presentation choices a preparer makes, and that choice is why operating cash flow reads Rs 36,30,000. Had the same Rs 3,50,000 been shown inside operating instead, operating cash flow would read Rs 32,80,000 and the conversion would fall from 67.9 per cent to 61.3 per cent, on identical trading and identical banking. One classification choice moves the figure by six percentage points here without a rupee changing hands. Before comparing anybody's cash conversion with anybody else's, find out where the interest was put.

Why does anybody use EBITDA as a stand-in for cash at all?

Because in a large number of ordinary businesses it is very nearly right, and it is available a great deal earlier. Depreciation and amortisation is usually the single largest non-cash charge on the statement, so removing it removes most of the difference between a profit figure and a cash figure in one stroke. An EBITDA figure can be built from a trial balance in an afternoon. An operating cash flow figure needs two full balance sheets and the movement in every short term balance between them.

Watch it work on the smallest possible business. Kadamba Tea Stall, invented, outside a bus depot. Everything is paid for at the counter in cash, the milk and the sugar are bought the same morning they are used, and the stall extends credit to nobody. Its EBITDA for a year is Rs 4,00,000, its working capital balances move by Rs 10,000, and it pays Rs 40,000 of tax, so its operating cash flow is Rs 3,50,000. The proxyA stand-in figure used because it is easier to get than the thing actually being measured, and reliable only where the two move together. is off by 12.5 per cent, almost all of which is the tax, and for many purposes that is close enough to be useful.

Now set Anjani Stationers beside it. The working capital drag on the tea stall is Rs 10,000 against EBITDA of Rs 4,00,000, or 2.5 per cent. The working capital drag on Anjani Stationers is Rs 17,00,000 against EBITDA of Rs 53,50,000, or 31.8 per cent. The tax drag is almost identical in the two, at 10.0 and 11.6 per cent. Wherever the working capital balances barely move, the stand-in holds up, and everything that goes wrong with it goes wrong through that one line. That is a genuinely useful thing to know, because it identifies exactly which businesses the shortcut holds for and exactly which it does not.

When does the stand-in fail worst?

Exactly where it is most relied on, and the coincidence is the uncomfortable part. Three conditions widen the gap, and the first is the one that matters most: growth. When sales rise, the balances that stand behind sales rise with them. More customers owe the business more money, and more stock has to sit on the shelf before it can be sold. Growth therefore consumes cash by arithmetic, not by mismanagement, and the faster the growth the more it consumes. The second condition is collection getting slower. Slower collection pushes the receivables balance up faster than sales are rising. The third is a heavy cash tax bill. Tax paid comes off the cash figure and never touches EBITDA at all.

Anjani Stationers has the first two together. Revenue grew 12.5 per cent in year two, from Rs 2,40,00,000 to Rs 2,70,00,000. Receivables grew 21.8 per cent, from Rs 78,00,000 to Rs 95,00,000. Growth alone would have pulled cash into the balances; growth plus slower collection pulled more. Hold every other line at Anjani Stationers' own figures, assume the working capital balances of Rs 80,00,000 keep the same relationship to sales as sales rise, and the conversion falls in a straight line as growth rises: 99.6 per cent at no growth, 80.9 per cent at Anjani Stationers' actual 12.5 per cent, 69.7 per cent at 20 per cent growth, and 39.8 per cent at 40 per cent growth.

Then mark where Anjani Stationers actually landed. At 12.5 per cent growth the line says 80.9 per cent, and the business reported 67.9 per cent. The gap of thirteen points is the collection getting slower, sitting on top of the growth. A business that is growing fast and collecting slowly is precisely the business whose EBITDA figure is most quoted and least reliable as a guide to cash.

What is Anjani Stationers' conversion, and what does it say?

Cash conversion here is operating cash flow divided by EBITDA. Rs 36,30,000 over Rs 53,50,000 is 67.9 per cent. Said in the plainest possible way: for every hundred rupees of EBITDA that Anjani Stationers reported in year two, about sixty-eight rupees turned into money in the bank from operations, and about thirty-two did not.

The ratio says less than it seems to. The ratio does not say that thirty-two rupees were lost or misappropriated. Most of the missing amount is still there, sitting inside the receivables and the inventory, and some of it will arrive next year when the schools pay. The ratio says that this year the money was somewhere other than the bank, and a business settles its wages and its instalments out of the bank rather than out of the receivables balance. The whole year is also worth holding together: Anjani Stationers earned a profit of Rs 30,00,000, generated Rs 36,30,000 from operations, spent Rs 34,00,000 on equipment and on buying 70 per cent of Chitra Binding, and finished the year with Rs 2,00,000 less cash than it started with.

A conversion of 67.9 per cent means about a third of the reported trading figure did not arrive as money this year, and it is a statement about where the money sat, not a statement about whether the business is well run. One year of it in a growing business is ordinary. The same reading three years running, with the receivables balance climbing each year, is a different conversation.

Seven settings of the working capital line show the shape of the leak. With the balances releasing Rs 10,00,000, operating cash flow is Rs 63,30,000 and the conversion is 118.3 per cent, more cash than EBITDA reported. With no movement at all, operating cash flow is Rs 53,30,000 and the conversion is 99.6 per cent, the tax paid being almost exactly offset by the provision added back. At an outflow of Rs 5,00,000, operating cash flow is Rs 48,30,000 and the conversion is 90.3 per cent. At Anjani Stationers' reported outflow of Rs 17,00,000, operating cash flow is Rs 36,30,000 and the conversion is 67.9 per cent. At Rs 25,00,000, operating cash flow is Rs 28,30,000 and the conversion is 52.9 per cent. At Rs 32,00,000, operating cash flow is Rs 21,30,000 and the conversion is 39.8 per cent. And at the bottom of the slider, an outflow of Rs 40,00,000, operating cash flow is Rs 13,30,000 and the conversion is 24.9 per cent, so three rupees in every four of the reported trading stayed in the balances.

What do a lender, an analyst and a buyer actually do with the pair?

None of them chooses between the two figures. A practitioner computes both, states the conversion, and treats the distance as the number carrying the information.

The lender's version is a discipline about basis. Anjani Stationers' EBITDA of Rs 53,50,000 and its operating cash flow of Rs 36,30,000 are Rs 17,20,000 apart, and any test of how comfortably a year's obligations are met will report roughly a third more room if it is written against the first figure than against the second. Neither figure is wrong, and the arithmetic is not in dispute. A careful reader writes both figures on the same line, says which one a test is built on, and then asks the separate question EBITDA cannot answer: of the Rs 53,50,000, how much reached the bank, and where is the rest sitting.

The analyst's habit is narrower and easy to copy. One year of 67.9 per cent in a growing business is ordinary and three years of it is a pattern, so the conversion is computed every year and the years are set beside each other. The shortfall is then split into its parts, exactly as the bridge does. The missing money can then be named as having gone into receivables, into stock, or to the tax authority. Receivables, stock and tax have very different implications and the single conversion figure does not distinguish between them.

The person buying a small business does the plainest version, and it is the wedding caterer's question again: what the trading earned, what actually reached the bank, and where the difference is sitting and how long it has been sitting there. The household version is the same arithmetic in miniature: a salary slip is the EBITDA, the money still in the account on the twenty-eighth is the operating cash, and the difference is the loan made to a cousin and the annual insurance premium that fell due. A practitioner never picks between EBITDA and operating cash flow; both are computed, the conversion is stated, and the distance between them is read as a description of where the year's money went.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Kadamba Tea Stall and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.