Challenging EBITDA metrics

Earnings before interest, taxes, depreciation and amortization (EBITDA) has a bad reputation in certain circles in the financial world. But is this financial measure worthy of investor disgust?

EBITDA is a frequently used measure of corporate value. But critics of this value often point out that this is a dangerous and misleading number because it is often confused with cash flow. However, this number can actually help investors establish an apple-to-apple comparison without leaving a bitter aftertaste.

Calculate EBITDA

EBITDA is calculated by adding interest, tax, depreciation and amortization expenses to net income. EBITDA is used to analyze the company’s operating profitability before non-operating expenses (such as interest and other non-core expenses) and non-cash expenses (such as depreciation and amortization). So, why does this simple number continue to be scolded in the financial world?

Critics of EBITDA analysis

Deducting interest, taxes, depreciation, and amortization can make a completely unprofitable company look financially healthy. Looking back at Internet companies in the 2000s, you can see countless examples of companies with no hope and income that have become the darlings of the investment world. Using EBITDA as a measure of financial performance makes these companies look attractive.

Likewise, EBITDA numbers are easy to manipulate. If fraudulent accounting techniques are used to exaggerate revenue without accounting for interest, taxes, depreciation, and amortization, almost all companies will look great. Of course, when the sales data becomes clear, the House of Cards will collapse and investors will be in trouble.

EBITDA and operating cash flow

Operating cash flow is a better way to measure how much cash a company generates because it adds non-cash expenses (depreciation and amortization) back to net income and includes changes in working capital that also use or provide cash (such as accounts receivable) Changes in payments), accounts payable and inventory).

READ ALSO:   Cost of Goods Sold (COGS)

These working capital factors are the key to determining how much cash the company generates. If investors do not include changes in working capital in their analysis and rely only on EBITDA, they will miss clues that indicate whether the company is losing money because it did not make any sales.

Positive factors for EBITDA

Despite the criticism, many people still like this convenient equation. Some facts are missing in all the EBITDA complaints, but its cheerleaders publicly promote them.

Estimate the cash flow of long-term debt

The first factor to consider is that EBITDA can be used as a shortcut to estimate the cash flow that can be used to pay long-term assets and liabilities, such as equipment and other items whose useful life is measured in decades rather than years. Divide EBITDA by the number of debt payments required to get the debt coverage ratio. Breaking down the “ITDA” of EBITDA is to consider the cost of long-term assets and provide the remaining profit after considering the cost of these tools. This is the use of EBIDTA before the 1980s and is a completely legal calculation.

The need for legal profitability

Another factor that is often overlooked is that for EBITDA estimates to be reasonably accurate, the company being evaluated must have legal profitability. Using EBITDA to evaluate established industrial companies may produce useful results. This idea disappeared when leveraged buyouts prevailed in the 1980s, and EBITDA began to be used as a proxy for cash flow. This has evolved into the recent practice of using EBITDA to evaluate unprofitable network companies and telecommunications companies, where technology upgrades are a constant cost.

READ ALSO:   Enterprise Value (EV)

Compare similar companies

EBITDA can also be used to compare companies’ mutual comparisons and industry averages. In addition, EBITDA is a good indicator of core profit trends because it eliminates some irrelevant factors and allows for more “one-to-one” comparisons.

Ultimately, EBITDA should not replace the measurement of cash flow, which includes important factors for changes in working capital. Remember “cash is king” because it shows “true” profitability and the company’s ability to continue operations.

Example: WT Grant Company

WT Grant’s experience illustrates the importance of cash generation to EBITDA. Before the emergence of commercial shopping centers, Grant was an integrated retailer and a blue chip stock at the time.

Unfortunately, Grant management made several mistakes. Inventory levels increase, and the company needs to borrow heavily to keep the doors open. Due to a heavy debt burden, Grant eventually went bankrupt, and the top analysts who only focused on EBITDA at the time missed out on negative cash flow.

The many missed calls at the end of the Internet age reflected Wall Street’s suggestions for Grant. In this case, the cliché is right: history does repeat itself. Investors should heed this warning.

READ ALSO:   Asset condition assessment

Some pitfalls of EBITDA

In some cases, EBITDA may produce misleading results. Long-term assets and liabilities are easy to predict and plan, while short-term debt is not. Regardless of EBITDA, lack of profitability is not a good sign of corporate health. In these cases, instead of using EBITDA to determine the health of the company and to value the company, it is better to use EBITDA to determine the time the company can continue to repay the debt without additional financing.

A good analyst understands these facts and uses calculations accordingly in addition to his or her other proprietary and personal estimates.

Best used in context

EBITDA does not exist in a vacuum. The bad reputation of this measure is mainly caused by overexposure and improper use. Just as a shovel can effectively dig holes, it is not the best tool for tightening screws or inflating tires. Therefore, EBITDA should not be used as a universal tool for assessing corporate profitability. This is a particularly valid point of view when people believe that the EBITDA calculation does not comply with Generally Accepted Accounting Principles (GAAP).

Like any other measure, EBITDA is a single indicator. To fully understand the health of any particular company, multiple measures must be considered. If identifying great companies is as simple as checking a number, then everyone will check the number, and professional analysts will no longer exist.


Share your love