Wharton School of the University of Pennsylvania reports;
After facing a daily barrage of news stories about alleged abuse by corporations, officers, and the accountants who are supposed to certify the validity of their statements, a weary public could be forgiven for wondering if the well of accounting and financial controversies has finally run dry.
An abridged version of a report by Knowledge@Wharton
According to Wharton faculty and other experts, not yet. The latest target, however, may not be a company or even an individual. Instead it is a concept, EBITDA, that may have been indirectly responsible for at least some of the corporate carcasses now littering the landscape.
EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, has been used by analysts and investors as a tool to measure the fiscal health of the many high tech, media and other asset-heavy firms that do not generate earnings, but instead incur plenty of depreciation, amortization, and other charges.
In the 1980s through the 1990s, many analysts and others believed that peeling away these expenses, which generally were not directly incurred in operations, would enable them to more accurately analyze and compare the core operations of companies. In fact, many treated EBITDA as a modified cash flow statement, sometimes mistakenly referring to it as free cash flow.
It should be noted, though, that while a cash flow statement reconciles a company’s net income or loss for a period to the company’s cash position as of the end of that period, EBITDA does not. EBITDA is also different from a free cash flow statement, which is basically EBITDA reduced by capital expenditures (purchases of generally long-lived assets like machinery, equipment or other items that show up on the balance sheet instead of the income statement). And of course, because EBITDA excludes so many expenses, it does not measure net income. In light of this, some people have questioned its usefulness.
John Percival, an adjunct finance professor at Wharton, is one who never quite accepted EBITDA as a valid tool. “In some of my classes, I call it EBIT Duh, “he says. “It is the lazy analyst’s cash flow and it is dangerous.”
Other accountants are also raising issues about EBITDA. Ben Neuhausen, the national director of accounting at BDO Seidman, notes that EBITDA continues to be valuable. But it needs to be used with care. As a measure of performance it is not a substitute for net income. “Just as EBITDA ignores cash outlays for capital expenditures that can be significant, it also ignores interest and other specified expenses that can account for a large part of a company’s cash outflow.”
EBITDA, Percival says, was originally used to assess the ability of a company to service its debt in the short run, about a year or two. Comparing EBITDA to interest expense would theoretically give a user an idea about whether there was sufficient operating income to meet interest payments. But because it ignored many sources of cash outflow (such as capital expenditures), a company could turn in stellar EBITDA, yet not have enough cash on hand to fund its interest and other payments. The problem was actually exacerbated in the 1980s when leveraged buyouts (LBOs), which typically incurred high levels of debt, began to sweep across the nation.
“In the 1980s people started to use EBITDA to find good candidates for LBOs,” (EBITDA was thought to be a good indicator of a company’s ability to meet debt payments), says Percival. They would project growing EBITDA in the future and say that the company could handle much more debt.”
Using an EBITDA-based analysis, says Percival, LBOs would then put “huge amounts of debt in companies and then later find that there was not sufficient cash to service the debt.”
But he notes that EBITDA makes some shaky assumptions, such as a presumption that all revenues are collected. It is ludicrous, he adds, to use EBITDA to value companies. The problem, according to Percival, is that company value is really an equity concept, and equity value comes from future free cash flow. Because it doesn’t consider capital-intensive and other cash expenditures, EBITDA is a poor approximation to free cash flow. Overall, except for very specific, limited applications, EBITDA is a dangerous number.
Article courtesy of the Wharton School of the University of Pennsylvania. The complete article can be read at: http://knowledge.wharton.upenn.edu/articles.cfm?catid=1&articleid=661&homepage=yes
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