EBITDA vs Free Cash Flow: Which Metric Matters for Business Valuation

Introduction

EBITDA and free cash flow are two of the most commonly referenced metrics in business valuation. If you've ever read a business sale advertisement or discussed valuation with an advisor, you've almost certainly encountered both.

But they measure fundamentally different things, and choosing the wrong metric can lead to a valuation that's significantly off—sometimes by millions of dollars. This article explains the difference, when to use each, and why free cash flow often provides a more reliable picture for Australian SMEs.

What Is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It's a proxy for operating cash flow—an attempt to measure the underlying profitability of a business independent of its capital structure and tax situation.

How it's calculated:

Net Profit
+ Interest Expense
+ Tax Expense
+ Depreciation & Amortisation
= EBITDA

The advantage of EBITDA is that it allows comparability between businesses with different debt levels, tax rates, and asset bases. It's widely used in valuation multiples (e.g., "4x EBITDA") and is the default metric in many business sale conversations.

What Is Free Cash Flow?

Free Cash Flow (FCF) measures the actual cash generated by a business after all operating expenses and capital expenditures are accounted for. It's the cash that's available to be distributed to shareholders, used for acquisitions, or reinvested.

How it's calculated (simple version):

Operating Cash Flow
- Capital Expenditure
= Free Cash Flow

A more refined calculation for valuation purposes is Unlevered Free Cash Flow (UFCF), which excludes the effects of debt:

EBIT (Earnings Before Interest and Tax)
- Tax on EBIT
+ Depreciation & Amortisation (non-cash expenses)
- Capital Expenditure
- Change in Working Capital
= Unlevered Free Cash Flow

Where They Differ

Capital expenditure

EBITDA ignores that businesses need to replace equipment, upgrade technology, and maintain facilities. A manufacturing business might show $2M in EBITDA but require $500K annually in capital expenditure just to maintain operations. EBITDA tells you nothing about this; FCF captures it directly.

Working capital requirements

Growing businesses consume cash through increasing receivables and inventory. A business that grows 30% year-on-year might look strong on EBITDA but actually have negative free cash flow because of working capital demands. FCF reveals this; EBITDA does not.

Debt service

While both metrics typically exclude financing costs for valuation purposes, EBITDA can mask the impact of debt service on a business's actual cash position. FCF analysis addresses this in the equity valuation context.

Tax

EBITDA ignores tax entirely. FCF accounts for tax, providing a more realistic picture of what owners can expect to receive.

When to Use Each in Valuation

EBITDA is more appropriate when:

• Comparing businesses in the same industry (it provides a standardised benchmark)
• Valuing asset-light businesses with minimal capex requirements (professional services, software)
• Using market multiple approaches where industry data is available on an EBITDA basis
• Early-stage discussions where simplicity is valued

FCF is more appropriate when:

• The business has significant capital expenditure requirements (manufacturing, transport, construction)
• Working capital cycles are long or volatile (retail, wholesale, property development)
• A discounted cash flow (DCF) analysis is being performed
• The buyer is a financial investor focused on cash returns
• The business is in a growth phase with substantial reinvestment needs

Example: Why the Difference Matters

Consider two businesses with identical EBITDA of $1.5M:

Applying a 4x EBITDA multiple to both would value them at $6M each. But a DCF analysis using FCF would show Business A being worth significantly more—because it actually generates more cash for owners after real-world costs.

A buyer using only EBITDA for the manufacturing business would overpay by a material margin.

To see how free cash flow feeds into a practical cash flow forecasting model in Excel, visit ExcelWiz.com.au.

Conclusion

Both EBITDA and free cash flow have their place in business valuation. EBITDA is useful for quick comparisons and industry benchmarking. But for a rigorous, defensible valuation—one that reflects the true cash-generating capacity of a business—free cash flow is the more reliable metric.

At BizVal, our valuations consider both metrics and select the appropriate methodology based on your business type, industry, and the purpose of the valuation. Contact us to discuss your requirements.

Frequently Asked Questions

Why do business brokers often use EBITDA rather than FCF?

EBITDA is simpler to calculate and communicate. It also tends to produce higher headline numbers, which can be advantageous in a sales context. Buyers and their advisors should always push for the FCF picture.

Does free cash flow include owner salaries?

In the context of SME valuation, owner salaries should be normalised to market rates before calculating either EBITDA or FCF. The goal is to measure the business's earning capacity independent of the current owner's compensation choices.

How do I calculate FCF for my own business?

Start with your net profit, add back non-cash expenses, adjust for changes in working capital (receivables, payables, inventory), and subtract capital expenditure. For a proper valuation, have a Chartered Accountant perform this analysis.

What's a healthy FCF conversion rate?

FCF as a percentage of EBITDA typically ranges from 60% to 90%. A rate below 50% suggests the business is capital-intensive or has significant working capital needs that should be factored into the valuation.