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.


Copyright © 2001 IDG Communications, Inc.

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