Usually, investors focus on tracking and observing cash flow, net income, and sales, which is a basic way of assessing a company’s health and value. However, in recent years, another valuation method has been used in quarterly reports and accounting operations – that is: earnings before interest, taxes and amortization (EBITDA). While EBITDA can be used to analyze and compare returns across companies and industries, investors should understand that it has certain limitations to what it can do. about the company. In this article we take a look at why this metric has become so popular and why in many cases it must be considered carefully.
Watching: What is Ebitda
EBITDA is a measure of profitability. According to generally accepted accounting principles (GAAP), there is no legal requirement that companies disclose EBITDA, which can be stated and reported using information contained in the financial statements of the company. a company.
Income, taxes, and interest are taken from the income statement, while depreciation is usually taken in the profit notes in the operating section or on the cash flow statement. The usual formula for calculating EBITDA is operating profit, also known as profit before interest and taxes (EBIT), and then adding depreciation.
EBITDA was first known in the mid-1980s when LBO (debt-based acquisition) investors examined declining companies that needed financial restructuring. They used EBITDA to quickly calculate whether these companies could pay interest on its financial transactions.
LBO (debt-based acquisition) banks use EBITDA as a tool to determine whether a company will be able to repay its debt in the near future (in a year or two?). At least in theory, the EBITDA -to -interest coverage ratio should show investors whether the company can afford the high interest expense payments later during restructuring. For example, a bank might argue that a company with an EBITDA of $5 million and interest expenses of $2.5 million has an interest coverage ratio of 2 – it can afford to pay off its debt.
EBITDA has since been widely used in a wide range of businesses. Its proponents argue that EBITDA is more of a reflection of a company’s operations by separating costs, but does not accurately reflect how the company is actually operating.
Interest rates, which are commonly used indicators of management’s choice of funding sources, are ignored. Tax is omitted because it can vary widely depending on acquisitions and losses incurred in previous years, which can distort net income. Finally, EBITDA eliminates subjective and erratic judgments when calculating depreciation, such as changes in useful life, residual value, and different depreciation methods.
By eliminating the above factors, using EBITDA it is easy to compare the financial position of different companies. It is also a useful tool for evaluating companies with different capital structures, tax rates and depreciation methods. At the same time, EBITDA also shows investors how much money a young or restructuring company can generate before it has to pay its creditors and the tax office.
EBITDA is becoming more and more popular because the biggest reason is that EBITDA shows more profit than just profit from business. It has become the choice for highly leveraged companies in capital-intensive industries such as cable television and telecommunications, where real profits are sometimes hard to come by. A company can brighten its financial picture by showing EBITDA, turning investors’ attention to earnings rather than just looking at debt and high expenses. .
While EBITDA may be a widely accepted performance indicator, treating it as the sole measure of earnings or cash flow can be misleading. Without other considerations, EBITDA provides an incomplete and dangerous picture of a financial situation. Here are four reasons to be wary of EBITDA:
Some analysts and journalists convince investors to use EBITDA to gauge cash flow. This advice is absurd and risky for investors, since taxes and interest are essentially cash. A company that doesn’t pay government taxes or take on debt is unlikely to be in business for long.
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Unlike other appropriate measures of cash flow, EBITDA ignores the change in working capital—cash required to cover day-to-day operations. This is the biggest problem in case of hot growing companies, requiring increased investment in accounts receivable and inventory to translate into growth in sales. Working capital investments deplete cash funds, but are ignored by EBITDA.
For example, Emergis, an information technology solutions company, achieved $28.4 million in EBITDA in fiscal year 2005. But if you look at the company’s cash flow statement, you’ll see that it consumed up to 48.8 million USD of working capital, making cash flow from operating activities negative. Clearly, EBITDA paints a more rosy financial picture than other measures.
Furthermore, while the cost of capital is a key and ongoing cash expense in most companies, EBITDA ignores the cost of capital. For example, US LED – a small media service provider. For the fourth quarter of 2005 , the company reported a $14.3 million EBITDA increase of 30 percent compared to the fourth quarter of 2004 ( Q4 2004 EBITDA was $11 million ) . However, this method does not take into account the huge capital costs of the company. Looking at US LEC’s quarterly report, we see that the company spent $46.9 million on capital equipment in the fourth quarter of 2005, in order to grow, it would need to continue spending every year on upgrades and expand your network. This number is important, but it is not shown in EBITDA.
Obviously, EBITDA doesn’t consider all aspects of the business, and by omitting important cash items, EBITDA actually overstates cash flow. Even if a company breaks even on an EBITDA basis, it will not generate enough cash to replace the underlying capital assets used in the company. Using EBITDA as a substitute for cash flow can be dangerous because it does not provide investors with sufficient information about the cost of cash. If you want to know the cash from the business then just look at the company’s cash flow statement.
EBITDA can easily make a company appear to have plenty of money to pay on loan interest. For example, a company has $10 million in operating profit and $15 million in interest expenses. By adding in the $8 million in depreciation expense, the company suddenly has an EBITDA of $18 million so it has enough money to cover the interest payments.
Depreciation is added back on the false assumption that these costs can be avoided. Although depreciation is not cash, it cannot be deferred indefinitely. Equipment inevitably wears out, and funds are needed to replace or upgrade equipment.
While subtracting interest payments, taxes, depreciation, and deductions from income may seem simple, different companies use different earnings figures as a starting point to calculate EBITDA. In other words, EBITDA is susceptible to accounting gimmicks found on the income statement. Even if we accept deviations in interest, taxes, and depreciation, the profit figure in EBITDA is still unreliable.
For example, a company may have excess or insufficient provisions for warranty, bad debt or restructuring costs. In this case, its earnings will be distorted and result in a bias in EBITDA. Furthermore, if the company has recognized revenue immediately after a sale or concealed ordinary expenses such as capital investments, EBITDA will provide little information to investors. Remember, EBITDA is only reliable when earnings are pouring in
The worst part is that EBITDA can make the company appear cheaper than it really is. When equity analysts look at the EBITDA stock price multiple rather than the earnings stream- EBITDA will show a lower multiple. Take for example a wireless telecom operator- Sprint Nextel. On April 1, 2006, the stock traded at 7.3 times the forecast EBITDA. That sounds like a low multiple, but it doesn’t mean the company is a bargain. As the forecast is based on revenue from the business Sprint Nextel trades at a much higher -20x. The company trades at 48x estimated net profit. Investors need to consider multiples other than EBITDA when assessing a company’s value.
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Although widely used, EBITDA is not mentioned in GAAP – as a result, companies can declare EBITDA however they want. The problem is that EBITDA doesn’t give a complete picture of a company’s performance. In many cases, investors are better off avoiding EBITDA or, if using it, in combination with other metrics that make more sense.
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