“EBITDA” is one of those terms that has received increased usage but usually for the wrong reason. This short article will define it and discuss how it can be useful but also misleading.
EBITDA is an abbreviation for “earnings before interest, taxes, depreciation and amortization.” It is calculated by taking operating income and adding back to it interest, depreciation and amortization expenses. 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).
EBITDA can be used to analyze the profitability between companies and industries. Because it eliminates the effects of financing and accounting decisions, EBITDA can provide a relatively good “apples-to-apples” comparison. For example, EBITDA as a percent of sales (the higher the ratio, the higher the profitability) can be used to find companies that are the most efficient operators in an industry.
The ratio can also be used to evaluate different industry trends over time. Because it removes the impact of financing large capital investments and depreciation from the analysis, EBITDA can be used to compare the profitability trends of, say, “heavy” industries (like automobile manufacturers) to hi-tech companies.
The new accounting rules that eliminate the amortization of goodwill, formally know as FAS 142, will bring operating income closer to EBITDA, but EBITDA will continue to be a better measure of core operating profitability.
EBITDA is good metric to evaluate profitability but not cash flow. Unfortunately, however, EBITDA is often used as a measure of cash flow, which is a very dangerous and misleading thing to do because there is a significant difference between the two.
Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income and includes the changes in working capital that also use/provide cash (such as changes in receivables, payables and inventories). These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether or not a company is losing money because it cannot sell its products!
It gets ugly when EBITDA is used as a key measure for making investment decisions. Because it is easier to calculate, EBITDA is often used as a headline metric in discussing a company’s results. This, however, could, as discussed above, misrepresent the true investment potential of a company because it does not accurately reflect a firm’s ability to generate cash.
EBITDA is a good measure to use to evaluate the core profit trends, but cash is king. EBITDA can be used to evaluate the profit potential between companies and industries because it eliminates some of the extraneous factors and allows a more “apples-to-apples” comparison.
But EBITDA should not replace the measure of cash flow, which includes the significant factor of changes in working capital. Cash is king because it shows “true” profitability and a company’s ability to continue operations.
The experience of the W.T. Grant Company provides a good illustration of the importance of cash generation over EBITDA. Grant was a general retailer in the time before malls and was a blue chip stock of its day; however, management made several mistakes. Inventory levels increased, and the company needed to borrow heavily to keep its doors open.
Because of the heavy debt load, Grant eventually went out of business, but the top analysts of the day that focused only on EBITDA missed the negative cash flows. Many of the missed calls of the end of the dotcom era mirror the recommendations Wall Street once made for Grant. History does repeat itself.