Historically, investors evaluating an M&A transaction analyze basic company metrics such as revenues, cash flow, and net income with a variety of financial tools to determine its financial health and value. Another analysis tool (EBITDA) has gained prominence since the 1980’s. It is now even reported on some company’s financials. Critics have arisen of this tool though, after some spectacular analytical failures.
EBITDA is an acronym: Earnings Before Interest Taxes Depreciation & Amortization
Instead of beginning with bottom-line figures like net-profit, EBITDA starts with earnings. Interest costs are stripped out since management may not be sourcing optimal financing. Taxes are not included since prior year losses and/or acquisitions can distort short-term net-income and may not reoccur. Depreciation and amortization are also removed. Subjective determinations create estimated residual values and the asset life-spans which then yield non-comparable values. These different methods of estimation can cloud a true earnings figure.
Proponents of EBITDA use it to evaluate:
- A company’s overall financial performance
- Analyze & compare profitability between companies and across industries
- A distressed company’s ability to pay out on a leveraged buyout transaction
- A company’s financial health versus companies using alternate depreciation policies affecting taxes
A WIDELY USED METRIC
Financial Institutions began to use EBITDA as a tool to determine if a company, raising debt for restructuring, could service a heavier interest payment.
Credit ratings agencies began to use this metric to assess the probability of default on issued debt. Companies with a high debt/EBITDA rating may be declined by potential lenders. The target ratio varies between industries since capital intensiveness and debt is not uniform.
Lending agreements may even set a Debt-to-EBITDA-Ratio on loans. Tracking this ratio can show the decline of earnings needed for debt service, triggering the loan to become due if the declining earnings trend is not corrected.
The use of this tool has spread as many investment analysts believe EBITDA better captures a company’s operational performance by not including expenses which may obscure its true financial performance. Investors primarily gain a better picture of what a company generates as strong earnings could be missed when obscured by expenses and taxes that might be better optimized.
DRAWBACKS
The earnings measure produced by EBITDA can be very misleading if it is the only metric being used. The higher earnings figure produced from this metric is advantageous for enterprises in industries requiring higher debt loads. But, if a buyer’s focus is drawn away from analysis of debt costs and evaluating expenses, the target company’s financial health may be misjudged. By itself, EBITDA is an incomplete analysis and can result in poor conclusions. Reasons why this is the case include the following.
- Taxation and interest payments are real cash items and are not optional
- Working capital needs, which are ignored, are critical for understanding receivables and inventory, which convert into sales growth
- More funds may appear available for debt payments when depreciation and amortization are not considered. These are non-cash items, but assets wear out and funds will be needed for replacements
- EBITDA is not a substitute metric for analyzing cash flow
Another drawback is that companies can use different earnings calculations for their starting number in EBITDA. Even when controlling for the distortions from interest, taxes, depreciation and amortization, the results EBITDA produces therefore are only as accurate as the accounting methods used to calculate earnings as reported on the income statement.
EBITDA isn’t recognized by GAAP (Generally Accepted Accounting Principles) and so companies can report EBITDA by the method they decide to. Varying methodology between companies means EBITDA figures are not able to produce true comparison values.
EBITDA can make a company appear less expensive than it actually is. Analysts producing value-price multiples of EBITDA, instead of using bottom-line earnings, yield lower multiples. Due diligence demands other value-price multiples be considered when analyzing operating profits and net income to correctly assess the enterprise’s true value.
ADJUSTED EBITDA
Adjustments to the standard formula can be made to remove anomalies from one company making its EBITDA results comparable to that of other companies. Idiosyncrasies might include redundant assets, bonuses paid to owners, rent paid outside fair-market values, one-time costs (legal fees, repairs, insurance claims), and non-recurring income.
Adjusted EBITDA can be helpful in analyzing the value of a company for M&A transactions or raising capital. The adjustments though, need to be carefully scrutinized as being truly non-recurring items, since earnings and thus value, can be overstated.
Analysts also opt at times to use a 3-year or 5-year EBITDA average to smooth out data spikes rather than rely on a quarterly calculation.
EBITDA RATIOS TO DEBT OR SALES
Another way EBIDTA can be made useful is in combination with other important financial figures to produce insightful ratios for consideration. These ratios are then analyzed for insight into particular areas of health or concern within the operations. For example:
- Net Debt-to-EBITDA ratios reveal a company’s ability to pay off short and long-term debt
- EBITDA-to-Sales ratios help access profitability of gross revenues and earnings
- Comparing the EBITDA margin and these other ratios over time can reveal the trajectory of s company’s financial health and its efforts regarding debt and profits
BOTTOMLINE ON EBITDA
EBITDA can be a useful tool in financial analysis when its limitations are understood.
Critics are right to point out it can be misleading and distort values, but this poor reputation has been gained mostly by the tool’s improper use. The dotcom crash, for example, reached inappropriate values reported by analysts largely using exclusively EBITDA measures.
Nonetheless, EBITDA handled properly is a useful tool, eliminating extraneous factors and allowing for “apples-to-apples” comparisons. EBITDA should not be the primary or only tool of analysis, but used in conjunction with other financial tools. Analysis of the quality of the company’s financial numbers then allows confidence of the data used in the EBITDA formula.
Understanding what EBIDTA means along with the limits of what it measures, means EBITDA can be a useful and insightful tool for analysis.