EBITDA is at the same time the most discussed and most maligned measure of business cash flow.  Simply put, EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization.  The problem with EBITDA is that too often analysts or market participants or writers want to think that there is a single measure of cash flow that will reveal all, bringing Utopia to valuation. This post notes 11 things that EBITDA is not or will not do—and compares other cash flow measures according to the same criteria. Utopia does not exist and there is no valuation elixir. Sadly, we actually have to analyze companies to value them or buy them or sell them.

The “Naughty 11” Problems with EBITDA

Googling “problems with EBITDA” yields 2.2 million results in 0.47 seconds. After reading down a few pages, I developed a list of eleven things that EBITDA is reputed not to do.  So business appraisers, business owners, and other market participants should beware.

The “naughty 11” are summarized in the following table.

Let’s look at the problems with EBITDA by the numbers from the table above.

1. EBITDA is not a GAAP (generally accepted accounting principles) measure.  For that, some folks give EBITDA a bad name.  It is nowhere to be found on audited financial statements.  Analysts actually have to select from the income statement the components that add to EBITDA. This post talks about how to “find” EBITDA.
2. EBITDA does not measure asset intensity.  That’s what some observers say.  However, one can look at the amount of depreciation and amortization in a calculation of EBITDA.  Then one can compare that amount with other companies. The relative amount of DA (depreciation and amortization) in EBITDA is actually a partial measure of capital intensity (or asset purchase intensity). One could also look at the balance sheet.
3. EBITDA does not tell anything about liquidity on a company’s balance sheet.  Now that’s a big problem.  One might actually have to look at the company’s balance sheet to determine its degree of liquidity.
4. EBITDA does not tell anything about debt levels on a company’s balance sheet.  One might look at the amount of interest expense in EBITDA and draw some inferences, but the exact amount of debt will never be revealed by EBITDA.  One might have to look at the company’s balance sheet to determine how much debt it has.
5. EBITDA does not reveal a company’s working capital needs.  That’s true.  One can analyze EBITDA until the cows come home and never learn how much working capital a company will need in the next period, or should have had in the current period. I like to look at the balance sheet and cash flow statement to begin to assess working capital needs, so I never expected EBITDA to inform me about working capital.  Others apparently do.
6. EBITDA does not reveal a company’s need for capital expenditures to replace existing plant and equipment as it wears out.  I’m old fashioned in this regard.  I like to look at a company’s historical balance sheets and talk to management about the need for replacement capex. EBITDA does, however, through DA, give an amount that was depreciated in the current (or historical) periods.  That DA can give a glimmer of current and future needs, especially when examined in light of capex showing on the cash flow statement.
7. EBITDA certainly does not reveal management’s intentions for reinvestment of current and future cash flows into capital expenditures to achieve future growth initiatives. Financial statements are based on history. The only way to understand a company’s future growth plans is to ask management about them.
8. EBITDA does not tell anything about the expenses of management or owner perquisites that have flowed through a company’s income statement. I’ve never understood this criticism because normalizing income statements for above-market compensation is a normal part of our valuation processes.
9. EBITDA does not reveal anything about non-cash items of income or expense (other that DA).  Again, I have to admit that this criticism is true.  Non-cash items usually show up on the income statement and on the cash flow statement.  If an expense does not require cash, the cash impact has to show up somewhere. We employ normalizing adjustments to examine the impact of such items on EBITDA and at other levels of the income statement.
10. EBITDA does not reveal anything about non-recurring items of revenues or expenses. We often find indications of such items on a company’s income statement or cash flow statement. However, we always ask management about non-recurring or unusual items for consideration in our analyses.
11. Finally, EBITDA may not be a useful measure of cash flow because it can be manipulated by unscrupulous (or motivated) parties.

So there we have the “naughty 11” problems with EBITDA. The discussion has made clear that EBITDA cannot reveal, at least directly, information about a company’s balance sheet or its cash flow statement. Nevertheless, EBITDA continues to get a bad rap from some writers and analysts.

Are the “Naughty 11”  Applicable to Other Cash Flow Measures?

The “naughty 11” are summarized in the figure above.  The list could be made longer, but eleven is a nice number and is enough.  We subjected several other possible measures of cash flow to the same “naughty 11” test.

The figure below shows the results of this testing in relationship to EBITDA.  The additional measures are EBIT (sometimes called operating income), NOPAT (net operating profit after taxes), Operating Cash Flow (NOPAT plus depreciation and amortization), and Debt-Free Net Cash Flow (or net cash flow to capital providers).

The interesting thing about this figure is that virtually all of the cash flow measures fail the same “naughty 11” test that we applied to EBITDA above.  EBIT, which on some financial statements is called operating income, could be a GAAP measure, but sometimes it is not.  And EBIT does not appear on income statements as EBIT.

When we move over to the far right of the figure, we see that we can get some partial information about working capital and capital expenditure needs.  But these needs do not come from any financial statement. They are developed by management or a business appraiser or a market participant based on what? Their reviews of the historical financial statements, knowledge about markets and discussions with management.

Looking at rows #8 to #11 in the figure, we see that no cash flow measure will reveal anything about owner perquisites, non-cash items, or non-recurring items absent thoughtful adjustment by analysts. Finally, every (any) measure of cash flow can be manipulated by the unscrupulous.

What is the Solution for the “Naughty 11”?

We have already revealed the solution for every problem in the “naughty 11” list for EBITDA.  There is no substitute for analyzing EBITDA and a company’s historical income statements, cash flow statements, and balance sheets. There is no substitute for thoughtful discussions with a company’s management regarding its past and expectations for its future.  These statements are as true for the cash flow measure known as EBITDA as they are for every measure of cash flow in the figure above or that anyone wants to devise.

In the next post, we will look at why many analysts focus on EBITDA as a beginning point for their cash flow analyses.  We will also see why, despite its bad press, substantial attention is paid to valuation based on EBITDA.

New Books on the Way

1. An Attorney’s Handbook for Buy-Sell Agreements (in production).  This book provides guidance based on 30-plus years of dealing with buy-sell agreements. Importantly, it provides for the first time ever, anywhere, draft template language for the valuation portions of buy-sell agreements that will work for clients or companies.  You will not want to miss this book!
2. Business Valuation: An Integrated Theory Third Edition (with Travis Harms). The draft is due to the publisher (Wiley) shortly and will be available subject to their publication schedule. This book updates the Integrated Theory of Business Valuation and will include the Integrated Theory on an equity basis and on an enterprise (total capital) basis, as well. This book will be must reading for all business appraisers and anyone interested in business valuation.

E-mail me if you would like to be notified when these books become available:

mercerc@mercercapital.com

Be well until next time,

Chris