The Daily Technical #74: What is the “going concern” assumption used in accrual accounting?

Good morning. Welcome to the 74th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
Is EBITDA a good proxy for operating cash flow?

To address whether EBITDA is a good proxy for operating cash flow, remember that EBITDA reflects earnings before interest, taxes, depreciation, and amortization, primarily focusing on non-cash expenses.

While it adjusts for depreciation & amortization and significant non-cash expenses, it fails to account for capital expenditures and changes in working capital, which are crucial for understanding cash flow.

Additionally, EBITDA overlooks stock-based compensation, though adjusted EBITDA often includes this factor.

For an accurate assessment of a company's operating performance and the potential to forecast future cash flows, consider these non-cash and non-recurring adjustments. Keep these insights in mind when discussing cash flow proxies.

Common Mistakes

1. Overlooking the impact of capital expenditures and working capital changes. Remember, EBITDA does not account for these cash outflows, so it's essential to recognize their importance in evaluating operating cash flow.

2. Failing to acknowledge that EBITDA excludes stock-based compensation. To accurately assess operational cash flow, consider including "adjusted EBITDA," which typically adjusts for SBC.

3. Assuming EBITDA directly reflects cash flow. It omits crucial elements like capex and changes in working capital, leading to inaccurate financial analysis.

TL;DR

• Use EBITDA cautiously for operational performance and cash flow forecasting:

  • EBITDA excludes capital expenditures and working capital changes, limiting its accuracy as a cash flow proxy.

  • Focuses only on non-cash expenses like depreciation and amortization.

  • Omits stock-based compensation, adjustable with "adjusted EBITDA."

  • Fails to capture full operational cash impact without nonrecurring adjustment.

TODAY’S QUESTION
What is the “going concern” assumption used in accrual accounting?

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