In the majority of distressed companies I\u2019ve worked on, the two most important measures of financial performance are not reviewed \u2013 Operating Income (EBIT) and Free Cash Flow. Instead EBITDA, Gross Profit and Net Income are the only profit measures included on the Income Statements.<\/p>\n
Operating Income is a superior measure of an operating company\u2019s income producing results. It includes all the costs and expenses management controls – including depreciation and amortization. Management generates depreciation through its capital expenditure decisions. If management invests capital with poor returns, EBITDA will be artificially inflated leading to wrong conclusions.<\/p>\n
In my experience, EBITDA is a misleading financial number for evaluating the financial performance and condition of an operating company.<\/p>\n
Free Cash Flow is superior metric for evaluating a company\u2019s financial condition. It signals a company’s ability to pay its bills as a \u201cgoing concern\u201d<\/em>. It is a measure that eliminates anything that is misleading in the Income Statement. It tracks the money and, in combination with Operating Income, is a better gauge of corporate health and earnings performance.<\/p>\n EBITDA is certainly useful to establish a company\u2019s Enterprise Value. However a multiple of Free Cash Flow should be considered as an alternative, and perhaps better, metric for establishing Enterprise Value.<\/p>\n