Published on May 5, 2016
1. 1 Reasons why EBITDA can be a fallacy By Zubin Poonawalla EBITDA, that widely-touted measure of company performance and indicator of value otherwise known as earnings before interest, taxes, depreciation, and amortization, is a fairy tale told to investors and credit managers so that they go to sleep happy instead of running for the hills. EBITDA purports to indicate a company’s pure operating performance, free of such esoteric characteristics as debt cost, tax burden, depreciation and amortization. In reality, EBITDA is akin to a blender, into which go normal financial statements and out of which comes a numberthat always seems to make the subject company look better than it did when the numbers went into said blender. Let’s take a look at five reasons why relying on EBITDA means buying into a great big lie. #5 – EBITDA makes companies with asset-heavy balance sheets look healthier than they may actually be. Understanding the amount of asset depreciation is of limited value in determining the present viability of a company; instead, it’s a measure of what the company has spent, in the past, on capital expenditures. For an owner or investor trying to evaluate the health of a company in advance of their busy season, that knowledge plus $1.29, will get them a medium cup of coffee at a local gas station
2. 2 convenience store. Depreciation and Amortization are “non-cash” items – in other words, they are meaningless MacGuffins in the context of a company’s fiscal health. As we’ve discussed before, if there’s one thing that a company in distress needs, it’s cash. Non-cash items are relegated to the irrelevancy bin where they rest comfortably between the cultural importance of the Jersey Shore season opener and Sarah Palin’s opinion on the White House holiday card. Worse, this measure leaves us blind as to the company’s future asset needs. That the company is booking depreciation on hard assets is fine and good – but, as Warren Buffet is credited as having said, “Does management think the tooth fairy pays for capital expenditures?” EBITDA leaves the viewer blind as to both short- and long-term asset replacement needs – and those require cash, debt, or both. #4 – EBITDA portrays a company’s debt service ability – but only some types of debt. EBITDA is a measure created by investment bankers to answer the question “How much debt can a buyer put on this company after it’s acquired?” And, for that EBITDA does a fine job, depending upon which spot in the debt structure a creditor occupies. The type of debt held by a given creditor may leave that creditor in a position that is either advantageous or highly precarious. Consider a hypothetical company that generates $10 Million in EBITDA this year –what this doesn’t show is a hypothetical $12 Million of interest payments on its senior secured credit facility that the company has to make between
3. 3 now and then. Simple math tells us that the company is now on the wrong side of a $2 Million cash shortfall. Unless you’re the senior secured lender and the EBITDA numberis in excess of your debt service for the period projected, EBITDA is of little practical value. 3 – EBITDA ignores working capital requirements Imagine you own a retail store chain, and it’s June. Like many retail chains whose sales are holiday-concentrated, the company’s Year-to- date EBITDA might be positive and its cash operations may be flirting with breakeven, if not showing outright losses. “But, our EBITDA is positive,” I hear this retail chain say. “How could anything be wrong?” Well, that positive EBITDA doesn’t reflect that, being June, our retail store has to start ordering for the holiday season, which means cash is going to be tied up in inventory. This means that the company is going to need cash – which it doesn’t have. So either it has to borrow more, which increases debt service costs, or it has to use what cash it has and do what we in the restructuring community call “building a war-chest” and what everyone in the trade credit community calls “stretching payables” and later calls “getting screwed.” Either way you choose to refer to it, EBITDA doesn’t reflect changes in working capital requirements. Working capital is cash and, as I will mention time and again, cash is king. #2 – EBITDA doesn’t adhere to GAAP
4. 4 If Generally Accepted Accounting Principles are the hallmark of transparency and consistency in financial reporting, then EBITDA is the funhouse Hall of Mirrors. Because EBITDA is essentially a tool that shows what a company would look like if it wasn’t actually that company (“Let’s see what this tax-paying, debt-ridden, asset-heavy company looks like without any debt, without tax burden, without assets and with no working capital needs!”), it is easily manipulated. And wait, there’s more – EBITDA doesn’t provide any consistency check for a company’s accounting practices as to how it arrives at its cash flow reporting. For example, I worked as a restructuring advisor on a case about 10 years ago where some of the related warehousing operations (who were not my client) reported EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization and Rent). We joked that, when you’re running an operation which is primarily real estate, the one thing that you have in abundance is Rent. So why exclude one of your principal operating expenses? I’ve seen this usedoften in retail operations as well – take a large, undeniable expense category and turn it into a positive, by choosing to report it in a manner that artificially inflates cash. What’s next – EBITDARE (EBITDAR, plus all other Expenses)? I’m sure if we go through the exercise, we’ll find that even the most underperforming company will look great on EBITDA once we add back all of its expenses. #1 – EBITDA can present a laundry list of bad information In 2000, Moody’s Investors Services released a report titled “Ten Critical Failings of EBITDA as the Principal Determinant of Cash
5. 5 Flow“ (free registration required). Personally, I think you only need one failing – EBITDA isn’t a determinant of cash flow at all. But, the folks at Moody’s, detail-oriented and insightful as they are, gave us ten reasons, which is probably why their report is widely respected and oft-cited and why I’m just a restructuring guy and a blogger. But back to the point: Summarizing what may be the most glaring example of how EBITDA is (mis)used, the Moody’s report, as well as countless others, stated that those who use EBITDA as the sole basis for determination of a transaction multiple are likely deserving of the results they get. While EBITDA multiples are one of many transaction multiples to consider when calculating purchase price of a business, there are many better ones to use – particularly when EBITDA is so easily manipulated. Consider, for example, the story of a company whose value varied wildly depending upon which metric was used: Value based on top-line revenue: $5 Million Value based on Gross Profit: $2.25 Million Value based on EBITDA: $8.5 Million Who got the better deal if the GAAP-compliant metrics yield values less than the non-GAAP-compliant metric? Then consider which buyer you want to be. Or, you could just pay based on EBITDA!!!