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.