Getting EBITDA and free cash flow right in credit deals

September 28, 2021

These non-standardized measures are important but because they mean different things to different people, they should be used carefully in credit raises and other contexts.

When WeWork was preparing for a bond issue in 2018, underwriters were raising concerns over its leverage. The company’s response wasn’t to reduce leverage by adding equity or lowering debt but by adjusting EBITDA until it got the ratio it wanted.“We all know how that story ended,” Andrew Holmes, a Moody’s Analytics director, said in a Moody's Analytics webcast last week.

By turning its $193 million loss in earnings before interest, taxes, depreciation, and amortization (EBITDA) in 2017 into a positive $233 million in what it called community-adjusted EBITDA, it erased its leverage problem without having to make any changes to its planned bond offering.

“People didn't believe in community-adjusted EBITDA,” he said, but that didn’t stop them from investing in the company.

It was one instance in which the company adjusted EBITDA to meet its short-term needs while masking a longer-term leverage problem that came to a head in 2019 when it had to pull its IPO because of valuation concerns.

Extreme case

Holmes called the WeWork saga a cautionary tale of misusing EBITDA, a metric that can provide a good measure of company performance over time and that’s useful for setting valuations but is too often seen as a proxy for cash flow or, in some cases, profitability.

It’s neither of those things, which is why EBITDA often increases while cash and profits decrease, and vice versa, depending on market conditions.

But because so many people use it, it’s important for accounting professionals to calculate it thoughtfully and consistently. “You want to be clear what it is,” Holmes said.

Non-GAAP measure

Accounting organizations are unlikely to treat EBITDA and its adjustments in a standardized way anytime soon.That’s because the metric, created by investment bankers to show growth promise, isn’t recognized under Generally Accepted Accounting Standards (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) elsewhere.Given the lack of standardization, organizations should do their own EBITDA calculation if they’re trying to raise credit capital and the lender looks at the measure in calculating leverage.“If you think someone’s going to calculate your EBITDA, you should do your own” and offer that number, he said.

In WeWork’s case, it changed a negative to a positive by first calculating adjusted EBITDA by making relatively common adjustments, including depreciation and amortization. WeWork then calculated what it called Adjusted EBITDA Before Growth Investments by adding back in costs that are typically excluded, such as those for sales and marketing and new market development.

It justified the adjustments on the grounds that, once new office buildings came online, they would generate revenue without the company having to pay those expenses anew.“So, add those back in,” Holmes said.It then made a subsequent adjustment — its Community Adjusted EBITDA — by adding back in general and administrative (G&A) expenses. It was “a new animal, never before seen in the wild,” he said.

Cash flow differences

Free cash flow (FCF) is another widely varying metric that lacks standardization but, like EBITDA, lenders commonly use it in underwriting loans. For that reason, if you’re seeking to raise credit capital from a lender that calculates payments based on it, you want to do your own calculation so you know what you’re facing .“Look at that and not EBITDA,” he said.

In general, FCF is the cash available to service lenders and shareholders and does things like acquisitions after the company has incurred expenditures that are effectively mandatory.

You can think of it as adjusted EBITDA but without interest, working capital changes, capital expenses, and some other line items, he said. Some organizations also exclude dividends, which Moody’s recommends. That’s because companies typically treat dividends, though discretionary, as mandatory.

“Kellogg's has paid a regular and rising dividend for decades,” he said. “If the chief executive of Kellogg's were to cut the dividend, would that impact his job prospects? You bet it would. Has he borrowed money in the past to pay his dividends? Yes, he has.” Private companies also treat dividends as mandatory, Holmes said.


Although EBITDA and FCF measure very different things and can move in opposite directions depending on companies' responses to changing market conditions, accounting teams should be prepared to do their own calculations when trying to raise credit capital.“

If you expect it to be repaid by cash flow, know how it's calculated,” he said. “Know how cash flow varies from sector to sector, and through the cycle.” Bottom line, both EBITDA and FCF, despite their lack of standardization, are useful measures, he said, but be thoughtful in using them.