EBITDA

The ROI and TCO Benefits of Data Deduplication for Data Protection in the Enterprise Sign up to receive Security Resource Alerts

January 08, 2001 (Computerworld) -- Increasingly popular in financial statements as a way to measure a company's cash flow, EBITDA has many flaws as a measurement tool and is actually quite different from cash flow, critics say.

EBITDA, which stands for "earnings before interest, taxes, depreciation and amortization," is a "fraud perpetrated on us by Wall Street—it's a joke," snorts Fred Hickey, editor of "The High-Tech Strategist," a Nashua, N.H.-based newsletter. "I don't think anyone should think about this at all. You should think about cash flow, earnings and sales; you can't just remove interest, taxes, depreciation and amortization."

EBITDA, which sounds like something Andy Kaufman's Taxi character Latka Gravas might say, can accurately measure cash flow if a company spends no money on debt interest or equipment purchases. More often, it's used as an accounting gimmick to dress up a company's financial picture to make it look rosier than it really is and deflect investor attention away from bad news, according to a report from Moody's Investors Service in New York.

While cash flow—the amount of cash left after money comes into and goes out of an organization during a certain time period—can't be gussied up to look like Cinderella at the ball, EBITDA is easy to manipulate by using "creative" accounting techniques for revenue, expenses and asset write-downs, according to the report "Putting EBITDA Into Perspective: The 10 Critical Failings of EBITDA as a Principal Determinant of Cash Flow".

Corporate filings with the Securities and Exchange Commission often include terse warnings that EBITDA doesn't mean net income, doesn't measure liquidity and isn't part of the Generally Accepted Accounting Principles.

EBITDA "creates the appearance of stronger interest coverage and lower financial leverage," says Pamela Stumpp, senior vice president of corporate finance at Moody's and lead author of the report, which was released last July. "Earnings are not cash but merely reflect the difference between revenues and expenses, which are accounting constructs. Thus, it is important to scrutinize revenue recognition policies, especially for capital-intensive start-ups."

Where It Works

EBITDA is inappropriate for many industries because it ignores their unique attributes, according to Moody's. It's a poor measure of cash flow for companies undergoing a great deal of technological change or for firms that have short-lived assets (those lasting, say, three to five years) and need to keep upgrading their equipment to stay up-to-date. But it can be a valid measurement tool for organizations whose capital-intensive equipment lasts at least 20 years.

Top 10 Critical Failings Of EBITDA 1. EBITDA ignores changes in working capital and overstates cash flow in periods of working capital growth. 2. It can be a misleading measure of liquidity (quick access to cash). 3. It doesn’t consider the amount of required reinvestment—especially for companies with short-lived assets, whether it’s cable equipment or trucks. 4. It says nothing about the quality of earnings. 5. It’s an inadequate stand-alone measure for a company’s acquisition multiples. 6. It ignores distinctions in the quality of cash flow resulting from differing accounting policies — not all revenues are cash. 7. It’s not a common denominator for cross-border accounting conventions. 8. It offers limited protection when used in indenture covenants. 9. It can drift from the realm of reality. 10. It’s not well-suited for the analysis of many industries because it ignores their unique attributes.

For example, the cable and media industries, which need to spend huge amounts of money to upgrade their technology, are ill-suited for using EBITDA, according to Moody's. So are industries that receive cash long after their earnings cycles have ended, such as the hospitality sector, which operates time-share resorts; Internet companies, at which barter often replaces cash receipts; and the trucking industry, in which trucks, whose value depreciates quickly, have to be frequently maintained before service begins to slide.

Then there's the technology industry.

"Along comes the Internet and, later, technology firms generally, [which] buy companies for huge amounts but amortize goodwill [the difference between what a company is valued at the time of purchase vs. the amount that is paid]—usually amortized over 30 to 40 years for companies with brick-and-mortar assets—over three to five years. This can make the earnings look 50% higher, even though the company's main asset leaves in the elevator every night," says Charles Hill, director of research at First Call/Thomson Financial in Boston, which analyzes earnings and forecasts. "It's making a silk purse out of a sow's ear."

A brief history: In the leveraged-buyout (LBO) mania of the 1980s, when many companies paid more than fair market value for assets, EBITDA became widely used to measure a company's cash flow—and thus its ability to service debt - by LBO sponsors and their lenders. (Prior to the '80s, earnings before interest and taxes, or EBIT, were used to measure a company's ability to pay its debts.)

Evolving Uses

Over time, EBITDA morphed into a measurement tool for cash flow at companies in "near-bankruptcy" mode, Moody's notes. Later, it was used to measure companies with long-lived assets such as steel furnaces and radio towers. Today, it's used by companies in all industries.

"Unfortunately, the use of EBITDA has evolved from its position as a valid tool at the extreme bottom of the business cycle—where it was used to assess low-rated credits—to a new position as an analytical tool for companies still in their halcyon days," Stumpp wrote in the Moody's report.

Of the 147 firms tracked by Moody's that went bankrupt in 1999, many of the U.S. firms borrowed cash based on their EBITDA, the report notes.

Livent Inc., a Toronto-based theatrical production company that filed for bankruptcy in late 1998, used to amortize huge preproduction expenses over a long time period in its EBITDA, despite running a high risk that those costs would never be recouped. In contrast, the EBIT for Livent—whose musicals included Show Boat and Ragtime—would have painted a truer picture of its financial condition, according to the Moody's report.

The greater the percentage of EBIT in EBITDA, the stronger the cash flow generally is, Moody's says. The higher the percentage of depreciation and amortization in a company's EBITDA, the more important it is that the company spends an amount equal to the depreciation value to keep its equipment current.

McDonnell is a freelance writer in Brooklyn, N.Y. Contact her at Sharonfmc@compuserve.com.

Print this Story

Send Us Feedback

E-mail this Story

Digg this Story

Slashdot this Story

"If you're controlling document transmission processes, don't overlook your multifunction printers, advises one vendor...." Read more... "What part of "Yahoo doesn't want a thing to do with you" did Ballmer not get? The new lord and..." Read more... Read more Management posts or See all Blogs

DNS hole prompts synchronized patching effort by IT vendors Microsoft plugs nine holes in Windows, DNS, SQL Symantec warns of new Word attack More top stories...

Microsoft sets XP SP3 automatic download for Thursday Don't give Google a free pass on data collection, privacy advocates say after YouTube ruling XP SP3 to reach most users 'shortly,' says Microsoft

This old laptop: Revitalizing an aging notebook on the cheap All it takes is a couple hours and about $125 to breathe new life into an old laptop. Here's how. Bill Gates moves on Is Microsoft's Golden Age over? What are Gates' most memorable quotes? Find out in Computerworld's complete coverage of the end of the Bill Gates era at Microsoft. Five things you should never tell your boss There are some things your CIO definitely doesn't want to hear. Also don't miss the flipside, Five things you should always tell your boss. Hands-On: Firefox 3 fixes what's broke and keeps what's right With its latest version, Mozilla's browser continues to raise the bar for what Web browsers should be. Windows Vista A to Z Reviews, analyses, how-tos, visual tours, hot issues and predictions about Microsoft's new OS. More Continuing Coverage After 9/11: Homeland SecurityAsk a Premier 100 IT LeaderBlackBerry Legal BattleData Security BreachesElectronic VotingFirefoxH-1B VisasHP's Boardroom ScandalHandheld DevicesHurricane Katrina AftermathMicrosoft Legal IssuesMicrosoft's VistaOpen SourceRFID TechnologySCO's Linux FightSarbanes-Oxley ActSpamVoice Over IPWi-FiWindows Meta File VulnerabilityWindows XP Service Pack 3 IT Careers 2010 Four years from now, the IT field will be a vastly different place. Will you be ready? More Special Reports Premier 100 IT Leaders 2007 Best in Class2006 Computerworld Horizon Awards2006 Premier 100 IT Leaders2006 Salary Survey2007 Best Places to Work in IT2007 IT Forecast2007 Premier 100 IT Leaders40 Years of ComputerworldASPs, Take TwoBest Places to Work in IT 2003Best Places to Work in IT 2004Best Places to Work in IT 2005Best Places to Work in IT 2006Business Intelligence Home RunsBusiness Intelligence: Smarter BIBusiness Intelligence: The Future of BICRM Goes VerticalCRM: Sober CRMCareer Planning Guide 2005Careers: IT Profession 2010Computerworld Horizon Awards 2005Data Management: Mining for GemsData Management: Taming Data ChaosDevelopment: Hard-Workin' Web SitesDevelopment: New Tools New ChoicesDevelopment: The New World of Application DevelopmentDevelopment: The Web Services TsunamiDevelopment: Web Services HurdlesDisaster Recovery: Preparing for the WorstE-commerce Grows UpE-mail/Groupware: Big DecisionsFaces of Mobile ITForecast 2006Global MobileHardware: Multiple Cores, Multiple ChallengesHardware: On-Demand Un-HypedHardware: The Shape of Things to ComeHorizon Awards: 10 Cool Cutting Edge TechnologiesIT Management: Guide to Managing VendorsIT Management: Navigating Global ITIT Management: Recovery AheadIT Management: The Future of ITIT Management: The Resourceful Project ManagerInnovative Technology Awards 2004Management: Reinventing ITMicrosoft in TransitionMobile/Wireless Leaders and LaggardsMobile/Wireless: The Untethered WorkerMobile/Wireless: Tiny Gadgets, Huge CostsNetwork Management: Taking ControlNetworking: Turbulence Ahead!Networking: VoIP Goes MainstreamOperating Systems: In the Slow LaneOperating Systems: Linux Goes GlobalOperating Systems: Should You Nix Unix?Outsourcing: Offshore Buyer's GuideOutsourcing: Outsourcing DangersPremier 100 IT Leaders 2004 Best in ClassPremier 100 IT Leaders 2005 Best in ClassROI: Do the Math!Salary Survey 2003Salary Survey 2004Salary Survey 2005Security Action PlanSecurity: Compliance HeadachesSecurity: Proactive SecuritySecurity: Risk and RewardSecurity: Tips From Security ProsSouped-up SecurityStorage: Battling ComplexityStorage: Cheap & Secure Data StoresStorage: Stretching Your Storage DollarsStorage: The Lean Storage MachineStorage: The New Rules of StorageStorage: The Ultimate Backup GuideSupply Chain: Missing LinksSupply Chain: RFID Reality CheckThe Business of SecurityWeb 2.0 SecurityWireless: Wireless At Work All Zones Application Performance Zone Business Continuity Zone Data Center Management Zone Enterprise-Class Security Zone The File Data Management Zone Grid Computing on Windows Zone Security Management Zone ITIL Best Practices Zone The SAS Zone Storage Virtualization Zone Business Intelligence and Analytics Zone See your link here

Does collaboration drive business success? Get this white paper now! (Source: Microsoft Office Live Meeting) Collaboration occurs at the intersection of an enterprise's technology and culture. Discover how these two critical factors affect the quality of collaboration in Meetings Around the World: The Impact of Collaboration on Business Performance. You'll learn why enterprises need to work collaboratively - and examine how collaboration impacts business success. Download this white paper  Avoiding the Latest Phishing Attacks Avoiding the Latest Phishing Attacks Watch this on-demand webcast right now for free, compliments of Computerworld and MessageLabs. Go to the webcast  Managing For Agility Get the full Computerworld report for a limited time, compliments of Computerworld and IBM. Today's corporations need to bend without breaking. Agile IT operations can deliver products and services promptly, and then they can update and improve and reconfigure those resources as need be. But only good management practices will keep it all working together. In this Executive Briefing, we'll look at best practices for providing and managing IT in an on-demand world. Download this executive briefing  White Papers Read up on the latest ideas and technologies from companies that sell hardware, software and services. Virtualization Analysis for VMware A Guide to Understanding Messaging Archiving Archiving Compliance with Sunbelt Exchange Archiver View more whitepapers

• DNS hole prompts synchronized patching effort by IT vendors
• Microsoft plugs nine holes in Windows, DNS, SQL
• Symantec warns of new Word attack
• More top stories 

Enhancing Business Mobility with Convertible PCs For years Pen enabled computing devices have enjoyed great success and acceptance in highly vertical industries like delivery services, auditing and POS. The primary limitations of early pen computing devices, which were the hurdles to early mainstream adoption, were the power limitations of the devices, no stable OS environment for application development, and the lack of a keyboard for traditional input. Now, with the availability of Windows XP Tablet PC edition and Vista, which are both Pen Enabled operating systems, the flexibility afforded by dual function convertible notebooks and a host of 3rd party applications, Pen Computing has expanded into areas like healthcare, insurance, education, retail, and sales force automation. What used to be strictly vertical has now caught on as a preferred alternative to standard notebooks. Is now the right time for you to consider pen computing? Tune in to find out what these amazing mobile devices can do to simplify tasks, expand the utility of a traditional notebook, and increase the ROI of traditional notebook computing. Listen to this podcast now

Intercept Spam & Viruses With MessageLabs MessageLabs is offering a complimentary 30 day trial of its managed Anti-virus and Anti-spam security solutions. MessageLabs guarantees complete protection against all know and unknown email threats. By providing 24 hour support, your business can increase productivity and decrease risk. Register for a complimentary trial and receive a free datasheet. Download this white paper now!