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EBITDA Equals Operating Cash Flow and Other Lies

June 28, 2016

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is useful in valuing a company but it certainly does not equal “cash flow.” EBITDA was invented as a way to value companies on an ‘apples-to-apples’ basis; it eliminates the impact of balance sheet choices and different tax rates.

That is all fine and good, but somewhere along the line EBITDA became a substitute for “operating cash flow.” Many SaaS company CEOs and CFOs have told us they have reached cash-flow break even because they are now EBITDA positive. Well, not really.

First off, interest expense is typically cash. Unless the debt has a “payment in kind” feature or does not pay current interest, the interest expense is a real, dollar-for-dollar use of cash. And if the business is net income positive, taxes also get paid in cash.

Depreciation and amortization, while not cash expenses themselves, are good estimates of cash needs for capital expenditures. The exception would be the amortization of goodwill or some other acquired intangible asset. If the business is also capitalizing and then amortizing software development, the cash disconnect is exacerbated because these cash investments are captured neither as an operating expense nor in EBITDA.

For these reasons EBITDA is not a good proxy for operating cash flow.

Another item around which there is some misinformation is deferred revenue, which is generated when the business charges customers in advance for services not yet rendered. It is most often the result of annual, paid in advance, contracts. This approach is great from a cash flow perspective when the business has a healthy, predictable growth rate. In some cases it can even eliminate the need for additional outside capital.

Two things to understand about deferred revenue:

  1. The positive cash impact of billing in advance is directly related to the growth of the business. If growth slows, the positive working capital benefit will shrink, and cash flow will decrease. If the growth rate of a company that is ‘cash flow positive’ because of upfront payments slows, it will start to burn cash even while its P&L improves. For this reason, we do not recommend including the working capital benefits of deferred revenue in “operating cash flow.” It is too dependent on new bookings.
  2. Deferred revenue makes for a smooth P&L, but choppy cash flow. The most dramatic examples are in seasonal businesses when the annual bookings, and thus the renewals, are all clustered in one quarter. The monthly P&L looks perfectly smooth all year, but the underlying cash flow swings dramatically. Cash flow is also choppy when these businesses are just scaling-up and only have 10 to 50 customers.

Obviously, SaaS Capital is a big fan of the SaaS business model, but there are a few nuances in how it manifests itself in the financial reports that operators and investors need to fully understand. Hypothetically, through deferred revenue accounting as well as software capitalization practices, an increasingly net income profitable SaaS company can run out of cash and go bankrupt!

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