Increasingly popular in financial statements as a way to
measure a company's cash flow, EBITDA has many flaws as a
measurement tool and is actually quite different from cash flow,
critics say.
 |
 |
|
Top 10 Critical Failings Of EBITDA
1. EBITDA ignores changes in working capital
and overstates cash flow in periods of working capital
growth.
2. It can be a misleading measure of liquidity
(quick access to cash).
3. It doesn’t consider the amount of required
reinvestment—especially for companies with short-lived assets,
whether it’s cable equipment or trucks.
4. It says nothing about the quality of
earnings.
5. It’s an inadequate stand-alone measure for
a company’s acquisition multiples.
6. It ignores distinctions in the quality of
cash flow resulting from differing accounting policies — not
all revenues are cash.
7. It’s not a common denominator for
cross-border accounting conventions.
8. It offers limited protection when used in
indenture covenants.
9. It can drift from the realm of
reality.
10. It’s not well-suited for the analysis of
many industries because it ignores their unique
attributes. |
EBITDA, which
stands for "earnings before interest, taxes, depreciation and
amortization," is a "fraud perpetrated on us by Wall Street—it's a
joke," snorts Fred Hickey, editor of "The High-Tech Strategist," a
Nashua, N.H.-based newsletter. "I don't think anyone should think
about this at all. You should think about cash flow, earnings and
sales; you can't just remove interest, taxes, depreciation and
amortization."
EBITDA, which sounds like something Andy Kaufman's Taxi character
Latka Gravas might say, can accurately measure cash flow if a
company spends no money on debt interest or equipment purchases.
More often, it's used as an accounting gimmick to dress up a
company's financial picture to make it look rosier than it really is
and deflect investor attention away from bad news, according to a
report from Moody's Investors Service in New York.
While cash flow—the amount of cash left after money comes into
and goes out of an organization during a certain time period—can't
be gussied up to look like Cinderella at the ball, EBITDA is easy to
manipulate by using "creative" accounting techniques for revenue,
expenses and asset write-downs, according to the report "Putting
EBITDA Into Perspective: The 10 Critical Failings of EBITDA as a
Principal Determinant of Cash Flow".
Corporate filings with the Securities and Exchange Commission
often include terse warnings that EBITDA doesn't mean net income,
doesn't measure liquidity and isn't part of the Generally Accepted
Accounting Principles.
EBITDA "creates the appearance of stronger interest coverage and
lower financial leverage," says Pamela Stumpp, senior vice president
of corporate finance at Moody's and lead author of the report, which
was released last July. "Earnings are not cash but merely reflect
the difference between revenues and expenses, which are accounting
constructs. Thus, it is important to scrutinize revenue recognition
policies, especially for capital-intensive start-ups."
Where It Works
EBITDA is inappropriate for many industries because it ignores
their unique attributes, according to Moody's. It's a poor measure
of cash flow for companies undergoing a great deal of technological
change or for firms that have short-lived assets (those lasting,
say, three to five years) and need to keep upgrading their equipment
to stay up-to-date. But it can be a valid measurement tool for
organizations whose capital-intensive equipment lasts at least 20
years.
For example, the cable and media industries, which need to spend
huge amounts of money to upgrade their technology, are ill-suited
for using EBITDA, according to Moody's. So are industries that
receive cash long after their earnings cycles have ended, such as
the hospitality sector, which operates time-share resorts; Internet
companies, at which barter often replaces cash receipts; and the
trucking industry, in which trucks, whose value depreciates quickly,
have to be frequently maintained before service begins to slide.
Then there's the technology industry.
"Along comes the Internet and, later, technology firms generally,
[which] buy companies for huge amounts but amortize goodwill [the
difference between what a company is valued at the time of purchase
vs. the amount that is paid]—usually amortized over 30 to 40 years
for companies with brick-and-mortar assets—over three to five years.
This can make the earnings look 50% higher, even though the
company's main asset leaves in the elevator every night," says
Charles Hill, director of research at First Call/Thomson Financial
in Boston, which analyzes earnings and forecasts. "It's making a
silk purse out of a sow's ear."
A brief history: In the leveraged-buyout (LBO) mania of the
1980s, when many companies paid more than fair market value for
assets, EBITDA became widely used to measure a company's cash
flow—and thus its ability to service debt - by LBO sponsors and
their lenders. (Prior to the '80s, earnings before interest and
taxes, or EBIT, were used to measure a company's ability to pay its
debts.)
Evolving Uses
Over time, EBITDA morphed into a measurement tool for cash flow
at companies in "near-bankruptcy" mode, Moody's notes. Later, it was
used to measure companies with long-lived assets such as steel
furnaces and radio towers. Today, it's used by companies in all
industries.
"Unfortunately, the use of EBITDA has evolved from its position
as a valid tool at the extreme bottom of the business cycle—where it
was used to assess low-rated credits—to a new position as an
analytical tool for companies still in their halcyon days," Stumpp
wrote in the Moody's report.
Of the 147 firms tracked by Moody's that went bankrupt in 1999,
many of the U.S. firms borrowed cash based on their EBITDA, the
report notes.
Livent Inc., a Toronto-based theatrical production company that
filed for bankruptcy in late 1998, used to amortize huge
preproduction expenses over a long time period in its EBITDA,
despite running a high risk that those costs would never be
recouped. In contrast, the EBIT for Livent—whose musicals included
Show Boat and Ragtime—would have painted a truer picture of its
financial condition, according to the Moody's report.
The greater the percentage of EBIT in EBITDA, the stronger the
cash flow generally is, Moody's says. The higher the percentage of
depreciation and amortization in a company's EBITDA, the more
important it is that the company spends an amount equal to the
depreciation value to keep its equipment current.
McDonnell is a freelance writer in Brooklyn, N.Y. Contact her
at Sharonfmc@compuserve.com.
Sites 
