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Understanding Financial Statements Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions

Cash Flow Analysis

 - The effects of growth on
    cash flow and earnings

 - How free cash flow
    benefits investors

 - Don’t blame EBITDA for
     your losses

 - The borrowing base
    impacts cash flow and equity
 - The debt repayment
    schedule can predict a
    liquidity crisis



Don’t blame EBITDA for your losses

In the early 1980’s many bankers would use EBITDA as a quick calculation for cash flow, to be used as a guide as to how much leverage a company could maintain. It was basically a quick “on the napkin” calculation used at dinner to see if a “deal” could be done, and what fees could be expected. Today, while it’s not suited for all industries or companies, on the whole it is a good method for investment bankers and company owners to use to open discussions/negotiations on a “deal.”

When the 2000 recession unfolded, articles were written which blamed the financial bubble, the ensuing recession and the associated collapse of a few of America’s largest companies on the over-reliance of EBITDA analysis. I never agreed with that assessment. Most of the professionals who use EBITDA are highly educated, trained, and experienced professionals. Their deals are “written-up” by trained credit analysts, and approved by managers, executives and committees. They are rated by credit agencies, syndicated out by investment bankers, and reviewed by multiple investment professionals and committees. All the participants involved in a transaction must give their nod of approval along the way.

These professionals realize that EBITDA has major drawbacks, such as:

·        It completely ignores the fact that accounting is based on accruals, not cash.

·        It totally disregards any changes in working capital, such as a buildup in inventory or accounts receivables, or the stretching of accounts payable, etc.

·        It ignores capital expenditure requirements.

·        It disregards unusual or nonrecurring transactions.

·        Liquidity is never mentioned because the lenders are usually providing the financing. EBITDA does not address liquidity.

·        It’s not useful for those companies whose accounting income is completely different from cash flow. For example, construction companies and defense companies use percentage-of-completion accounting, where cash advances on projects are different from accounting income. Leasing companies follow SFAS #13, which is materially different than cash accounting.

Investment bankers mainly used EBITDA for M&A activity.  Central bankers, moreover, use EBITDA guidance to influence the credit supply. By changing EBITDA multiples that commercial lenders are giving, credit can easily be extended or restricted.

Investors should view EBITDA as just another informational tool among many, to help them make investment decisions. It may be an incomplete measure of cash flow, but it is a useful and quick calculation, if fully understood. Appreciate EBITDA, and use it as intended, but remember its drawbacks.




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