EBITDA has a bad rap in the financial world, but does this financial measure really deserve the investor distaste? EBITDA, an acronym for "earnings before interest, taxes, depreciation and amortization," is an often-used measure of the value of a business. But critics of this value often point out that it is a dangerous and misleading number, due to the fact that it is often confused with cash flow. In this article we'll show you how this number can actually help investors create an apples-to-apples comparison, without leaving a bitter aftertaste.

The Calculation
EBITDA is calculated by taking net income and adding interest, taxes, depreciation and amortization expenses back to it. 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). So, why is this simple figure continually reviled in the financial industry?

The Critics
Factoring out interest, taxes, depreciation and amortization can make even completely unprofitable firms appear to be fiscally healthy. A look back at the dotcoms provides countless examples of firms that had no hope, no future and certainly no earnings, but became the darlings of the investment world. The use of EBITDA as measure of financial health made these firms look attractive.

Likewise, EBITDA numbers are easy to manipulate. If fraudulent accounting techniques are used to inflate revenues and interest, taxes, depreciation and amortization are factored out of the equation, almost any company will look great. Of course, when the truth comes out about the sales figures, the house of cards will tumble and investors will be in trouble.

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 or 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 a company is losing money because it isn't making any sales. (To learn more about cash flow, see The Essentials Of Cash Flow and Analyze Cash Flow The Easy Way.)

The Cheerleaders
Despite the critics, there are many who favor this handy equation. Several facts are lost in all the complaining about EBITDA, but they are open promoted by the value's cheerleaders.

  1. The first factor to consider is that EBITDA can be used as a shortcut to estimate the cash flow available to pay debt on long-term assets, such as equipment and other items with a lifespan measured in decades rather than years. Dividing EBITDA by the amount of required debt payments yields a debt coverage ratio. Factoring out the "ITDA" of EBITDA was designed to account for the cost of the long-term assets and provide a look at the profits that would be left after the cost of these tools was taken into consideration. This is the pre-1980s use of EBIDTA, and is a perfectly legitimate calculation.

  2. Another factor that is often overlooked is that for an EBITDA estimate to be reasonably accurate, the company under evaluation must have legitimate profitability. Using EBITDA to evaluate old-line industrial firms is likely to produce useful results. This idea was lost during the 1980s, when leveraged buyouts were fashionable, and EBITDA began to be used as a proxy for cash flow. This evolved into the more recent practice of using EBITDA to evaluate unprofitable dotcoms as well as firms such as telecoms, where technology upgrades are a constant expense.

  3. EBITDA can also be used to compare companies against each other and against industry averages.

  4. In addition, EBITDA is a good measure of core profit trends because it eliminates some of the extraneous factors and allows a more "apples-to-apples" comparison.

Ultimately, EBITDA should not replace the measure of cash flow, which includes the significant factor of changes in working capital. Remember "cash is king" because it shows "true" profitability and a company's ability to continue operations.

Example - EBITDA Analysis

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 commercial malls and was a blue chip stock of its day. Unfortunately, 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, and 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. In this case, the old cliché is right: history does tend repeat itself. Investors should heed this warning.

The Caution
In both cases No.1 and No.2 listed above, EBITDA is likely to produce misleading results. Debt on long-term assets is easy to predict and plan for, while short-term debt is not. Lack of profitability isn't a good sign of business health regardless of EBITDA. In these cases, rather than using EBITDA to determine a company's health and put a valuation on the firm, it should be used to determine how long the firm can continue to service its debt without additional financing.

A good analyst understands these facts and uses the calculations accordingly in addition to his or her other proprietary and individual estimates.

The Conclusion
EBITDA doesn't exist in a vacuum. The measure's bad reputation is more a result of overexposure and improper use than anything else. Just as a shovel is effective for digging holes, but wouldn't be the best tool for tightening screws or inflating tires, so EBITDA shouldn't be used as a one-size-fits-all, stand-alone tool for evaluating corporate profitability. This is a particularly valid point when one considers that EBITDA calculations do not conform to generally accepted accounting principles (GAAPs).

Like any other measure, EBITDA is only a single indicator. To develop a full picture of the health of any given firm, a multitude of measures must be taken into consideration. If identifying great companies was as simple a checking a single number, everybody would be checking that number and professional analysts would cease to exist. (For more insight on EBITDA, read A Clear Look At EBITDA.)

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