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Normally, investors focus on cash flow, net income and revenue as the basic measures of corporate health and value. But in recent years, another measure has crept into quarterly reports and accounts: earnings before interest, taxes, depreciation and amortization (EBITDA). While EBITDA can be used to analyze and compare profitability between companies and industries, investors should understand that there are serious limits to what the metric can tell them about a company. Here we look at why this measure has become so popular and why, in many cases, it should be treated with caution.

EBITDA: A Quick Review

EBITDA is a measure of profits. While there is no legal requirement for companies to disclose their EBITDA, according to the U.S. generally accepted accounting principles (GAAP), it can be worked out and reported using information found in a company's financial statements.

The earnings, tax and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT), and then add back depreciation and amortization. (To learn more, read Understanding The Income Statement, What Is A Cash Flow Statement? and Advanced Financial Statements Analysis.)

EBITDA Rationale

EBITDA first came to prominence in the mid-1980s as leveraged buyout investors examined distressed companies that needed financial restructuring. They used EBITDA to calculate quickly whether these companies could pay back the interest on these financed deals.

Leveraged buyout bankers promoted EBITDA as a tool to determine whether a company could service its debt in the near term, say over a year or two. Looking at the company's EBITDA-to-interest coverage ratio – in theory, at least – would give investors a sense of whether a company could meet the heavier interest payments it would face after restructuring. For instance, bankers might argue that a company with EBITDA of $5 million and interest charges of $2.5 million had interest coverage of 2 – more than enough to pay off debt. (To read more, see Looking At Interest Coverage and Spotting Disaster.)

The use of EBITDA has since spread to a wide range of businesses. Its proponents argue that EBITDA offers a clearer reflection of operations by stripping out expenses that can obscure how the company is really performing.

Interest, which is largely a function of management's choice of financing, is ignored. Taxes are left out because they can vary widely depending on acquisitions and losses in prior years; this variation can distort net income. Finally, EBITDA removes the arbitrary and subjective judgments that can go into calculating depreciation and amortization, such as useful lives, residual values and various depreciation methods. (For more insight, see Appreciating Depreciation and What is the difference between amortization and depreciation?)

By eliminating these items, EBITDA makes it easier to compare the financial health of various companies. It is also useful for evaluating firms with different capital structures, tax rates and depreciation policies. At the same time, EBITDA gives investors a sense of how much money a young or restructured company might generate before it has to hand over payments to creditors and the taxman.

All the same, one of the biggest reasons for EBITDA's popularity is that it shows higher profit numbers than just operating profits. It has become the metric of choice for highly leveraged companies in capital-intensive industries such as cable and telecommunications, where bona fide profits are sometimes hard to come by (see Why is EBITDA commonly used as a valuation metric for telecommunications companies?). A company can make its financial picture more attractive by touting its EBITDA performance, shifting investors' attention away from high debt levels and unsightly expenses against earnings.

The Drawbacks

While EBITDA may be a widely accepted indicator of performance, using it as a single measure of earnings or cash flow can be very misleading. In the absence of other considerations, EBITDA provides an incomplete and dangerous picture of financial health. Here are four good reasons to be wary of EBITDA:

1. No Substitute for Cash Flow

Some analysts and journalists urge investors to use EBITDA as a measure of cash flow. This advice is illogical and hazardous for investors: for starters, taxation and interest are real cash items and, therefore, they're not at all optional. A company that does not pay its government taxes or service its loans will not stay in business for long.

Unlike proper measures of cash flow, EBITDA ignores changes in working capital, the cash needed to cover day-to-day operations. This is most problematic in cases of fast-growing companies, which require increased investment in receivables and inventory to convert their growth into sales. Those working capital investments consume cash, but they are neglected by EBITDA.

For example, Emergis, an information technology solutions company, highlighted $28.4 million EBITDA for the fiscal year 2005. But if you turn to the company's cash flow statement, you'll see that it consumed $48.8 million in additional working capital, which largely accounts for Emergis' negative cash flow from operations. Clearly, EBITDA paints a rosier financial picture than other measures.

Furthermore, EBITDA neglects capital expenditures – a critical, ongoing cash outlay for almost every company. Consider US LEC, a small communications service provider. In its Q4 2005 earnings release, the company reported $14.3 million EBITDA. That represents a 30% improvement from Q4 2004, when it reported EBITDA of $11 million. But this measure disregards the company's sky-high capital expenditures. Looking at US LEC's 8-K filing, we see that the company spent $46.9 million on network capital equipment in Q4 2005; in order to grow, it will need to continue spending annually to upgrade and expand its networks. This number is significant, but it is not part of the EBITDA mix.

Clearly, EBITDA does not take all of the aspects of business into account, and by ignoring important cash items, EBITDA actually overstates cash flow. Even if a company just breaks even on an EBITDA basis, it will not generate enough cash to replace the basic capital assets used in the business. Treating EBITDA as a substitute for cash flow can be dangerous because it gives investors incomplete information about cash expenses. If you want to know the cash from operations, just flip to the company's cash flow statement. (To learn more, see The Essentials Of Cash Flow.)

2. Skews Interest Coverage

EBITDA can easily make a company look like it has more money to make interest payments. Consider a company with $10 million in operating profits and $15 million in interest charges. By adding back depreciation and amortization expenses of $8 million, the company suddenly has EBITDA of $18 million and appears to have enough money to cover its interest payments.

Depreciation and amortization are added back based on the flawed assumption that these expenses are avoidable. Even though depreciation and amortization are non-cash items, they can't be postponed indefinitely. Equipment inevitably wears out, and funds will be needed to replace or upgrade it.

3. Ignores Quality of Earnings

While subtracting interest payments, tax charges, depreciation and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from interest, taxation, depreciation and amortization, the earnings figure in EBITDA is still unreliable.

Let's say, for example, that a company has over- or under-reserved for warranty cost, bad debt or restructuring expenses. If this is the case, its earnings will be skewed and, as a result, EBITDA will be misleading. Furthermore, if the company has recognized revenues prematurely or disguised ordinary costs as capital investments, EBITDA will provide little information to investors. Remember, EBITDA is only as reliable as the earnings that go into it. (For further reading, check out Earnings: Quality Means Everything and Everything You Need To Know About Earnings.)

4. Makes Companies Look Cheaper Than They  Are

Worst of all, EBITDA can make a company look less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than bottom-line earnings, they produce lower multiples. Consider the wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn't mean the company is a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much higher 20 times. The company traded at 48 times its estimated net income. Investors need to consider other price multiples besides EBITDA when assessing a company's value.

The Bottom Line

Despite its widespread use, EBITDA isn't defined in GAAP. As a result, companies can report EBITDA as they wish. The problem with doing this is that EBITDA doesn't give a complete picture of a company's performance. In many cases, investors may be better off avoiding EBITDA or using it in conjunction with other, more meaningful metrics.

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