EBITDA is earnings before interest, tax, depreciation and amortisation. Free cash flow is operating cash flow minus capital expenditure. EBITDA adds back the accounting cost of assets wearing out; free cash flow subtracts the actual cash spent replacing them. For asset-heavy businesses that gap is the whole difference.
Free Cash Flow = Operating Cash Flow − Capital Expenditure
What each one is trying to do
EBITDA exists to compare operating performance across companies with different debt loads, tax positions and asset ages. Strip those out and you get something closer to a like-for-like view of the operations. That is a legitimate purpose and it is why private equity and credit analysts use it.
Free cash flow is asking a different question: how much cash could an owner actually take out this year after keeping the business running? It includes the interest, includes the tax, and subtracts the capital spending, because all three consume real money.
Worked example
A company reports $400M operating profit, $250M depreciation, $60M interest, $70M tax, $310M operating cash flow and $280M capital expenditure.
EBITDA = $400M + $250M = $650M
Free cash flow = $310M − $280M = $30M
A twenty-fold gap on the same company in the same year. The depreciation added back was not fictional: the company spent $280M replacing the assets it represents.
Munger's objection
Charlie Munger's line was that every time you see the word EBITDA you should substitute the words "bullshit earnings". The objection is specific rather than rhetorical: for a business that must continually replace machinery, vehicles or infrastructure, depreciation is the truest expense it has, and adding it back describes a company that does not exist.
The counter-argument holds for asset-light businesses. A software company whose depreciation is mostly amortisation of past acquisitions genuinely does not need to spend that cash again, and there EBITDA and free cash flow converge.
Which to use, by business type
- Asset-heavy, meaning manufacturers, telecoms, energy, transport: free cash flow, and treat EBITDA as close to meaningless.
- Asset-light, meaning software and services: either works, and free cash flow is still the better default once you subtract stock-based compensation.
- Heavily indebted companies: EBITDA is what lenders measure covenants against, so it is worth knowing even when it flatters. Read it alongside interest coverage.
- Companies in heavy expansion: free cash flow understates them, because growth capex is an investment rather than a cost. This is the one case where EBITDA tells the friendlier and arguably fairer story.
The tell worth watching
Compare capital expenditure to depreciation over five years. If capex runs consistently near or above depreciation, the add-back in EBITDA is money the company genuinely spends, and EBITDA is fiction. If capex runs well below depreciation, either the assets really are lasting longer than the schedule assumes, or the company is underinvesting and a bill is accumulating.
Which measure fits depends on the phase
Free cash flow understates a company still building capacity and describes a mature one precisely. Phase Check reads any US-listed company's financials and places it on the lifecycle, which is what decides the right measure.
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Frequently asked questions
Related
- Free cash flow, the full guide, and where it gets flattered
- How to read a cash flow statement, where both figures come from
- Enterprise value, the numerator usually paired with EBITDA
- Interest coverage, what EBITDA covenants are measured against