The Number Banks Love, and Why you Should be Suspicious of it
There is a number that appears in almost every corporate earnings release, every leveraged buyout pitch, every bank credit memo, and almost every discussion of whether a company is financially healthy.
That number is EBITDA, Earnings Before Interest, Taxes, Depreciation, and Amortisation.
And in my view, it is one of the most overused and most misleading metrics in corporate finance.
This is not a fringe opinion. Charlie Munger once called EBITDA “Bullsh*t earnings.” Warren Buffett has spent decades explaining why depreciation is a very real cost that management teams conveniently prefer to ignore. But despite those warnings, EBITDA remains the dominant lens through which banks assess a company’s ability to repay debt, and the dominant shorthand through which analysts compare businesses.
The better alternative, Operating Cash Flow, sits right there in every set of financial statements, far more revealing, far harder to manipulate, and almost universally ignored in favour of the number that makes everything look bigger.
Here is why that matters, and why as a long-term investor, you should train yourself to reach past EBITDA every time.
What EBITDA Actually Is
EBITDA starts with net income and adds back four things: interest expense, tax expense, depreciation, and amortisation. The resulting number is supposed to represent a company’s core operating earnings, what the business generates before the effects of how it is financed, how it is taxed, and how its assets wear out over time.
The logic behind the addbacks seems reasonable on the surface. Interest expense varies depending on how much debt a company carries, strip it out so you can compare businesses with different capital structures. Tax rates vary by jurisdiction, strip those out too. Depreciation and amortisation are non-cash charges, add them back because no cash actually left the building when the accountant recorded them.
The problem is that the moment you reconstruct EBITDA in your mind, you realise it lives entirely in the income statement. It is built from revenue and expenses as recognised by the company’s accountants, not from cash that actually moved. And that distinction, which seems technical, turns out to be enormous in practice.
What Operating Cash Flow Actually Is
Operating Cash Flow (OCF) starts in a completely different place. It begins with net income and then adjusts for everything that happened between the income statement and the company’s actual bank account.
The most important adjustments are the working capital movements: things like changes in accounts receivable (money owed to the company by customers), inventory (goods sitting in a warehouse waiting to be sold), and accounts payable (money the company owes to its suppliers).
These three items represent the business cycle in brief, the lag between when revenue is recognised on the income statement and when cash actually arrives, and the lag between when expenses are recognised and when they are actually paid.
A company that books $100M in revenue but has not yet collected any of it has a wonderful income statement and an empty bank account. OCF captures that reality. EBITDA does not.
Why EBITDA Is Almost Always Higher
Here is a mechanical truth that most financial commentary glosses over: in most businesses, in most years, EBITDA will be higher than Operating Cash Flow. Sometimes significantly higher.
The reasons are structural. Working capital typically consumes cash as a business grows, receivables and inventory expand as sales increase, and this cash outflow never touches the income statement. Meanwhile, depreciation and amortisation, which were added back to create EBITDA, represent real economic consumption of the asset base that will eventually require real cash to replace. A piece of machinery that depreciates over ten years does not magically regenerate itself at the end of year ten. The cash to replace it has to come from somewhere.
When you add back depreciation to create EBITDA and then use that number to assess a company’s financial health, you are implicitly claiming that the machinery doesn’t need replacing. Every manufacturing company knows that is not true.
The Manipulation Problem
EBITDA is not just theoretically imprecise. It is also practically easy to inflate.
The most straightforward manipulation is recognising revenue aggressively. A company can book a sale the moment goods leave the warehouse, even if the customer hasn’t paid or won’t pay for six months. That revenue flows directly into EBITDA. It does not flow into Operating Cash Flow, where the receivables balance would swell visibly and alert any attentive analyst that something is off.
This is not a hypothetical risk. It is one of the most common patterns in corporate fraud.
Sunbeam, the American appliance manufacturer, provides a textbook case. In the late 1990s, CEO Al Dunlap, known as “Chainsaw Al”, drove reported earnings higher by selling products to retailers at heavily discounted prices with generous return rights, recognising the revenue immediately. EBITDA looked healthy. Operating Cash Flow told a very different story, the company was consuming cash at an alarming rate as receivables ballooned. Sunbeam filed for bankruptcy in 2001.
Closer to the present, many highly leveraged companies that appeared financially manageable through the EBITDA lens, revealed their true fragility when interest rates rose and their working capital cycles deteriorated. The income statement said they were profitable. The cash flow statement said they were running dry.
Why Banks Use EBITDA Anyway
If EBITDA is so flawed, why does almost every bank in the world use it as the primary measure of debt capacity?
The answer is partly historical, partly structural, and partly, I will be direct, because it serves the bank’s commercial interests.
Historically, EBITDA became the standard in leveraged finance during the 1980s leveraged buyout boom. Dealmakers needed a metric that could justify higher debt levels on acquisitions, and EBITDA, which ignores working capital movements, strips out the cost of replacing assets, and excludes the interest expense on the very debt being assessed, produced the highest possible number. It became institutionalised.
Structurally, the banking system adopted it so broadly that any single bank switching to OCF-based underwriting would be at a competitive disadvantage, they would approve smaller loans than their peers, lose deals, and see revenue decline. The incentive to use the more conservative metric is weak when competitors are not.
And then there is the commercial reality: a higher EBITDA justifies a larger loan. A larger loan generates more fee income, more interest income, and a bigger balance sheet. There is a direct financial incentive for the banking system to use the metric that produces the highest debt capacity, and EBITDA is that metric.
I spent fifteen years in institutional finance. I have sat in credit committees where the EBITDA multiple was the headline figure and the cash flow statement was barely discussed. This is not a theoretical observation, it is a standard practice.
What to Use Instead
Operating Cash Flow is not perfect either. It can be managed through timing of receivables collections, stretching of payables, and opportunistic working capital draws before year-end. A skilled CFO can compress the working capital cycle in the fourth quarter to produce a better-looking OCF number than the underlying trend warrants.
But the manipulation is harder, the signals are clearer, and the number is fundamentally more honest because it reflects cash that actually moved.
For assessing a company’s debt capacity, OCF minus maintenance capex, what some call Owner Earnings or Free Cash Flow, is the most relevant figure. It represents what the business actually generated after keeping the existing asset base functional. That is what is available to service debt, pay dividends, fund growth, or return to shareholders. EBITDA does not answer that question cleanly. FCF does.
For comparing profitability across businesses, operating margin, operating income as a percentage of revenue, is a more reliable starting point than EBITDA margin, because operating income includes depreciation and therefore acknowledges the cost of the assets generating the revenue.
The Investor’s Takeaway
When I look at a business, I use EBITDA as a starting point at most, a rough orientation before I do the real work. The questions that matter to me are:
How does Operating Cash Flow compare to EBITDA? If the gap is consistently large, I want to understand why. A large and growing gap is often the first sign that something is wrong in the working capital cycle.
Is FCF growing alongside revenue, or is the business consuming more cash as it scales? A business that grows revenue but consistently burns cash is not compounding, it is borrowing against the future.
What is the capex-to-OCF ratio, and how much of capex is maintenance versus growth? Maintenance capex is not optional. It should never be ignored when assessing a business’s true earning power.
EBITDA will tell you what a company wants you to think about its earnings. Operating Cash Flow will tell you what is actually happening.