Lets Understand Why is EBITDA Used As A Proxy For Cash Flow?

Except in capital-intensive industries such as oil and gas, EBITDA is a fantastic proxy for cash flow, especially in the financial sector.

EBITDA reduces the business to its most basic operating cash flows because it eliminates any cash adjustments resulting from changes in the business's capital structure, the impact of a jurisdiction's laws, or management decisions.

For example, the cost of financing and interest is a proponent of the capital structure of the company. When considering cashflows to investors, the idea of using EBITDA as a proxy makes sense because it removes the impact of debt structures from the equation. If a company currently borrows funds at 4 percent instead of 12 percent, this does not reflect the company's operations, but rather the current financing environment in which the company operates.

In a similar vein, by removing taxes from the equation, you eliminate any external impact of the jurisdiction that is not indicative of the business operations. If a company is established in California rather than Nevada, this does not preclude the company from reorganising in the future to take advantage of a more favourable tax structure. Once again, this is not a reliable indicator of the operating cashflows of the company.

Finally, it is true that EBITDA does not take into account capital expenditures, which is why EBITDA is only a good proxy for industries that do not require significant capital expenditures. The oil and gas industry, for example, relies on the expenditure of cash to drill additional wells in order to run its operations effectively and efficiently.

However, if you look at the retail industry, the decision to renovate the store (capital investment) is a decision made by management in order to try to increase profits by improving the customer experience. This renovation may not take place under a different management team, and as a result, the proforma cash flows will not be accurate.

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