EBITDA Pro’s and Con’s

1 02 2011

EBITDA Pro’s and Con’s

By: George D. Abraham

Business Evaluation Systems

 

EBITDA, an acronym for “earnings before interest, taxes, depreciation and amortization”, is an often-used measure of the value of a business.

EBITDA is calculated by taking operating income and adding depreciation and amortization expenses back to it. EBITDA is used to analyze a company’s operating profitability before non-operating expenses (such as interest and “other” non-core expenses) and non-cash charges (depreciation and amortization).

Critics of EBITDA claim that it is misleading due to the fact that it is often confused with cash flow and factoring out interest, taxes, depreciation and amortization can make even completely unprofitable firms appear to be fiscally healthy.  Looking back at the dotcom companies, there are countless examples of companies that had no hope, future or earnings and the use of EBITDA made them look attractive.

Also, EBITDA numbers are easy to manipulate.  If fraudulent accounting techniques are used to inflate revenues and interest, and taxes, depreciation and amortization are factored out of the equation, almost any company will look great. Of course, when the truth comes out about the sales figures, the house of cards will tumble and investors will be in trouble.  In the mid-nineties when Waste Management was struggling with earnings, they changed their depreciation schedule on their thousands of garbage trucks from 5 years to 8 years. This made profit jump in the current period because less depreciation was charged in the current period. Another example is the airline industry, where depreciation schedules were extended on the 737 to make profits appear better. When WorldCom started trending toward negative EBITDA, they began to change regular period expenses to assets so they could depreciate them. This removed the expense and increased depreciation, which inflated their EBITDA. This kept the bankers happy and protected WorldCom’s stock.

Another concern is that EBITDA does not take into account working capital. It could be helpful to also point out that EBITDA is not a generally accepted accounting principal.

Because EBITDA can be manipulated like this, some analysts argue that a it doesn’t truly reflect what is happening in companies. Most now realize that EBITDA must be compared to cash flow to ensure that EBITDA does actually convert to cash as expected.

To sum up the cons:

 

1. EBITDA ignores changes in working capital and overstates cash

flow.

 

2. EBITDA can be a misleading measure of liquidity.

 

3. EBITDA does not consider the amount of required investment.

 

4.  EBITDA ignores distinctions in the quality of cash flow resulting

from different accounting policies.

 

5. EBITDA deviates from the GAAP measure of cash flow because it

fails to adjust for changes in operations-related assets and

liabilities.

On the plus side, EBITDA makes it easier to calculate how much cash a company has to pay down debt on long term assets. This calculation is called a debt coverage ratio. It is calculated by taking EBITDA divided by the required debt payments. This makes EBITDA useful in determining how long a company can continue to pay its debt without additional financing.

Overall, EBITDA is a stripped down, uncomplicated look at a company’s profitability. It eliminates the subjectivity of calculating amortization and depreciation. Depreciation and amortization are unique expenses. First, they are non-cash expenses – they are expenses related to assets that have already been purchased, so no cash is changing hands. Second, they are expenses that are subject to judgment or estimates – the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.

EBITDA takes out interest which is a result of management’s choices of financing. And, it removes taxes which can vary greatly depending on numerous situations

 

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