As discussed earlier this week, EBITDA (earnings before interest, taxes, depreciation, and amortization) can be used to analyze and compare profitability among companies and industries as it eliminates the effects of financing and accounting decisions.
David Sneddon, assistant vice president of sponsor finance at BMO Harris Bank, believes having a standard definition of free cash flow ensures “an apples-to-apples comparison when looking at similar companies.”
It also allows investors to assess organizations with different capital structures and depreciation systems.
All other things being equal, the business with higher EBITDA margins “is worth more because every dollar of revenue is going to translate into more cash flow,” he adds.
Arguments Against EBITDA
Unfortunately, EBITDA can be manipulated to appear better than it really is. Companies can inflate their EBITDA value by prepaying income taxes, choosing to use accelerated schedules to “front-load” depreciation expense, or by valuing their intangible assets too high, to report more amortization expense on an annual basis.
Numbers can also be engineered to look worse in favor of making net income look better. In 2002 the New York Times reported a “multiyear effort to inflate reported profits at Waste Management using accounting tricks that allowed the company to hide about $1.7 billion in expenses from 1992 through part of 1997.”
The company avoided depreciation expenses for its garbage trucks by extending their estimated life “while simultaneously making unsupported increases in their salvage value.”
This is a reminder that financial measures are only as good as the quality of the underlying financial reporting. Garbage in, garbage out.
For companies with significant interest expense, is it fair to “pretend” the interest they’re paying simply doesn’t exist?
And in the words of Warren Buffet, “Does management think the tooth fairy pays for capital expenditures?”
For businesses with high ongoing CapEx needs, Sneddon recommends EBITDA be adjusted downward using an average level of capital expenditures.
Butler reminds us that though EBITDA is an important measurement tool, its usefulness is limited, as it takes further analysis to see how a company “withstands recessions, cost increases, and decreases in revenue” by digging into the historical financial statements. Certainly, EBITDA can be a useful tool for assessing performance, but it’s important to realize it is only one of many financial gauges.
This is an excerpt from the most recent Produce Blueprints quarterly journal. Click here to read the full version.