EBITDA vs Net Income Vs Free Cash Flow (Analyst Explains)

Summary

This video by financial educator Brian Faldi explains three key profit metrics: net income, free cash flow, and EBITDA. Net income reflects a company's accounting profit, using accrual accounting, which records revenue and expenses when they are earned or incurred. Free cash flow measures actual cash generation after reinvestments, using cash accounting, which tracks when money is exchanged. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) shows operating profit by focusing on core business activities. The video also highlights the strengths and weaknesses of these metrics and provides practical insights for investors analyzing financial statements.

Takeaways

• 💼 Net income shows a company's accounting profit by subtracting expenses from revenue, as reported on the income statement.
• 🧾 Accrual accounting records revenue and expenses when they are earned or incurred, regardless of cash flow.
• 🚗 Depreciation spreads out the cost of an asset over its useful life, as shown by the car analogy.
• 📉 Free cash flow measures how much cash a company generates after reinvesting in its business, found in the cash flow statement.
• 💵 Cash accounting records transactions only when money changes hands, unlike accrual accounting.
• 🏢 Capital expenditures (CapEx) represent the money a company spends on long-term assets like equipment or property.
• 📊 EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) focuses on a company's operating profit, making it easier to compare firms with different capital structures.
• 🛠 EBITDA excludes non-operational factors, which can make it easier to compare companies but also easier to distort the reality of a business’s financial health.
• 📚 Alphabet (Google) had $73.7 billion in net income, $69.5 billion in free cash flow, and $84.2 billion in EBIT in 2023.
• 🔍 Tools like FinChat allow investors to easily look up key financial figures like net income, free cash flow, and EBITDA from financial statements.

Q & A

What is net income and how is it calculated?

Net income is the accounting profit of a company, calculated by subtracting all expenses from revenue. The formula is: Revenue - Expenses = Net Income.

What is the difference between accrual accounting and cash accounting?

Accrual accounting records revenue and expenses when they are earned or incurred, regardless of when cash is received or paid. Cash accounting records revenue and expenses only when cash changes hands.

Why can net income and free cash flow be different?

Net income is calculated using accrual accounting, which can include non-cash expenses and revenue. Free cash flow, on the other hand, uses cash accounting and reflects the actual cash generated by a business after reinvesting in it.

How is free cash flow calculated?

Free cash flow is calculated by subtracting capital expenditures (money spent on property, equipment, etc.) from cash flow from operations. The formula is: Cash Flow from Operations - Capital Expenditures = Free Cash Flow.

What is depreciation, and how does it affect financial statements?

Depreciation is the process of spreading the cost of an asset (like a car) over its useful life. It appears as an expense on the income statement, but since it's a non-cash charge, it doesn’t reflect actual cash outflow during the period.

What is EBITDA and how is it calculated?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is calculated by taking net income and adding back interest, tax expenses, depreciation, and amortization. The formula is: Net Income + Interest + Taxes + Depreciation + Amortization = EBITDA.

Why do investors use different profit metrics like net income, free cash flow, and EBITDA?

Investors use different profit metrics because each one provides different insights. Net income shows overall accounting profit, free cash flow reflects actual cash generation, and EBITDA focuses on operating profit by ignoring non-operating costs.

What are the advantages and disadvantages of using net income as a profit metric?

The advantage of using net income is that it gives a clear picture of a company’s profitability based on accrual accounting. However, it can be distorted by one-time events or non-cash expenses, making it less reliable for short-term assessments.

How does capital expenditure affect free cash flow?

Capital expenditures (money spent on long-term assets like property and equipment) reduce free cash flow because they represent cash that is reinvested into the business. This is subtracted from cash flow from operations to calculate free cash flow.

What are the pros and cons of using EBITDA to measure profitability?

EBITDA is useful for comparing companies with different capital structures because it excludes interest, taxes, depreciation, and amortization. However, it can be misleading as it ignores real expenses like taxes and interest, which can affect a company's financial health.