EBITDA vs. free cash flow are two financial metrics that often find themselves head-to-head for companies between $2 million and $10 million in revenue. Which is better?
In the world of scaling your business, two financial metrics often find themselves head-to-head — EBITDA vs. free cash flow. These two financial heavyweights each claim to be the ultimate measure of a company’s performance, but is that true?
What’s the difference, and which one is better? Let’s find out! Below, you’ll learn:
EBITDA is short for Earnings Before Interest, Taxes, Depreciation, and Amortization.
While this metric has its critics, it’s still a widely used and appreciated metric for founders and CEOs looking to understand their company’s operational efficiency and profitability potential.
Your company can’t survive if you aren’t generating profits, and EBITDA eliminates the noise and offers a clear picture of your earnings without things like interest expenses and tax rates. From there, you can more accurately assess your strengths and areas of improvement.
Let’s look at some key advantages of leveraging EBITDA as a financial metric.
By stripping away things like tax environments, interest expenses, accounting policies, and more, you can easily compare your operating performance against competitors. EBITDA is beneficial when looking at acquisition targets or benchmarking against industry competitors.
EBITDA reveals your company’s raw earning power and indicates your ability to generate cash. It’s a valuation tool for investors to assess your company’s value relative to performance because it indicates whether you’re generating enough money to survive long-term.
Paying attention to financial metrics like EBITDA means you can see early red flags that signal potential issues before they become huge problems. While EBITDA can signal that you need to course-correct, you shouldn’t use it as your only metric to inform decision-making.
While EBITDA gives you a glimpse into your operational efficiency, it has limitations. You don’t want to over-rely on this metric because it can be dangerously misleading. Let’s look at some of the downsides of using EBITDA to assess your business's health and future.
EBITDA means removing interest, taxes, depreciation, and amortization, but those expenses are very real business costs. Those expenses have a direct impact on profitability and cash flow, and ignoring them can hurt your business in the long run.
People often mistake EBITDA for cash flow, but they aren’t the same thing. Even worse, if you view them as the same thing, you could inflate your numbers, and they won’t accurately represent your actual capabilities of generating cash. Without healthy cash flow, you can’t make investments, service your debt, or provide returns to shareholders.
EBITDA can hide your organization’s debt and create a situation where you can inflate revenues and distort your value. You don’t want EBITDA as your single source of truth because it’ll blind leaders to operational realities and future risk.
Free cash flow is the only money that’s “free” within your organization. That means you can invest in growth initiatives, debt repayments, dividends, and other strategic decisions. As a founder or CEO, it’s one of the most important metrics you can track. While EBITDA reveals your cash-generating abilities, FCF shows you the real numbers after accounting for operating expenses, taxes, and other business expenses.
Let’s look at some of the upsides of using free cash flow as a metric for the health and success of your business.
EBITDA can be mistaken for being all about profitability, but its profitability based on gross margins. Free cash flow strips away distortions and non-cash expenses, so you can see how much cold, hard cash is left over for everything else that’s necessary to grow your business.
Economic headwinds are inevitable when you’re playing the long game. Surprises happen on an individual business level, and they also occur on a macro level. Free cash flow gives you a safety net to navigate hard times and economic downturns, ensuring you make it to the other side.
Positive free cash flow means you have money to invest in your organization’s future. You can reinvest it in R&D, sales and marketing, and other strategic initiatives that give you a leg up against competitors.
If you’re looking to fundraise or plan for an exit, the people on the other side will look at this metric. Why? Because it tells them whether you’re building a sustainably profitable company. It shows that your company can provide good returns on their investments.
If you’re relying solely on free cash flow to determine the health of your business, you might be setting yourself up for problems. Yes, it provides valuable insights into your company’s financial health and ability to weather the storms, but focusing only on a single metric can distort the bigger picture.
Let’s dive into some pitfalls of relying too heavily on free cash flow to make business decisions. After we check out the cons, we can look at EBITDA and free cash flow head-to-head to determine the best metric for evaluating business success.
Free cash flow may change week-to-week, month-to-month, and quarter-to-quarter. It’s volatile, so you want to track other metrics and take a zoomed-out look at this metric to determine what’s going on. A bad month might give a false signal that you have a problem, but if you’ve got positive long-term free cash flow, pay attention to that.
Negative free cash flow is expected if you’re a hyper-growth company. It’s hard to be profitable when investing in massive growth opportunities, and things are moving fast. If you’re a hyper-growth company, prioritizing free cash flow can actually stunt your long-term growth potential.
If you’re focusing too heavily on short-term free cash flow, you increase your risk by ignoring the balance sheet. Also, calculating free cash flow requires accurate reporting and forecasting. So, if you aren’t classifying expenses properly, it could lead to a manipulated number and problems down the line.
EBITDA and free cash flow are only single pieces of the puzzle. You don’t want to prioritize one too heavily over the other, and instead, pay attention to several performance indicators like profitability, revenue growth, market trends, etc.
The most successful founders and CEOs take a balanced approach. While EBITDA vs. free cash flow each has its strengths and weaknesses, you can view these as a dynamic duo, complementing each other and providing a more comprehensive view of your business’s financial health.
EBITDA can help identify areas of operational improvement and cost optimization; free cash flow gives you a more accurate representation of your organization’s ability to generate real cash.
As your company scales, the financial metrics you monitor and optimize for become increasingly critical for making strategic decisions and investments. No single number will ever tell the complete story of your business. Hiring an experienced fractional CFO can provide immense value, leveraging a holistic view of your organization to provide financial transparency and help drive sustainable growth.
At Lineal, our fractional CFOs provide a unified performance framework, leveraging insights from EBITDA and free cash flow, along with accurate reporting, KPI tracking, budgeting, and more. Using a multi-faceted approach, we keep a financial pulse on your business so you can course-correct as needed.
As an established market leader or a high-growth startup, you want to be able to make data-driven decisions that balance short-term profitability with long-term sustainable growth.
A fractional CFO can use EBITDA to pinpoint areas for improvement and optimize operational profitability and then tap into free cash flow metrics to drive sustainable expansion and unlock untapped opportunities.
So, which is better, EBITDA vs. free cash flow? Neither or both, depending on how you look at it. The more information you have about your company’s financial situation, and from all angles, the better off you’ll be.
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