By Ted Gavin, Managing Director, Founding Partner, Gavin/Solmonese LLC
You’re a financial professional looking to reassure your company’s creditors of the soundness of your company’s financial footing. To do so, you need to act with determination to show that your interests in the creditor’s products or services are aligned with the creditors’ interests in getting paid. But there is a difference between being determined and being deluded. Showing the creditors or lenders what your cash flow is after payment of their debt, that’s being determined. If you want to know what might be deluded, take a look at that article title up there one more time and read on.
Some people might mistakenly call EBITDA a measure of a company’s performance and an indicator of value that is otherwise broken down as earnings before interest, taxes, depreciation and amortization. I prefer to call it a fairytale told to investors and credit managers so that they go to sleep happy instead of running for the hills. While EBITDA purports to show a company’s pure operating performance, free of such burdens as debt cost, taxes, depreciation and amortization, in reality, EDITDA is more like a financial food processor – in go normal financial statements and out pops a number that generally makes the company look better than it did when the numbers went into that food processor.
“Why might this be” I hear you say?
First, EBITDA May Make Companies With Asset-Heavy Balance Sheets Appear Healthier Than They Are
In reality, understanding the amount of a company’s asset depreciation is of limited-to-no value in determining the actual present viability of a company. Instead, this is an indication of what the company did spend, in some past period, on capital expenditures. For a business manager or credit professional trying to evaluate the health of a company in advance of their busy season, that knowledge plus a couple dollars will get them a medium cup of coffee at their local convenience store. Depreciation and amortization are “non-cash” items – in other words, they are meaningless in the context of a company’s fiscal health.
Contrary to the validity of non-cash items, if there’s one thing that any company facing the harsh truth of distress needs, it’s cash. Non-cash items are relegated to the irrelevancy bin where they rest comfortably between the cultural importance of the name Snooki selects for her baby and Sarah Palin’s opinion on Paul Ryan as running-mate du jour. Worse, this measure leaves the observer blind as to the company’s future asset needs. That the company is booking depreciation on hard assets is fine and good, but, as Warren Buffet said, “Does management think the tooth fairy pays for capital expenditures?” EBITDA leaves the viewer blind as to both short- and long-term asset replacement needs – and those require cash, debt or both.
Sure, EBITDA Reflects a Company’s Debt Ability to Service Debt – But Only Some Types of Debt
Investment bankers created EBITDA to answer the question: “How much debt can a buyer put on this company after it’s acquired?” For that, EBITDA does an acceptable job, except that it’s entirely dependent on which spot in the debt structure a given creditor happens to occupy. In short, if you’re the company’s management, you need to know and speak to your audience. If you’re a creditor, you need to know where you live in the capital structure relative to the target company, because the type of debt held by a given creditor may leave that creditor in a position that is either advantageous or highly precarious.
Consider a hypothetical company that will generate $10 million in EBITDA this year -what this doesn’t show is a hypothetical $12 million of interest payments on its senior secured debt facility that the company will make between now and then. Simple math shows that the company is now on the ugly side of a $2 million cash shortfall. Unless you’re the senior secured lender and the EBITDA number is in excess of your debt service for the period projected, EBITDA is of little practical value in reassuring anyone of anything.
EBITDA Ignores Little Annoyances Like Working Capital Requirements
Imagine you own a retail store chain, and it’s June. Like many retail chains whose sales are holiday concentrated, the company’s year-to-date EBITDA might be positive and its cash operations may be flirting with breakeven, if not showing outright losses. “But, our EBITDA is positive,” one retail chain says. “How could anything be wrong?”
As an aside, if I had a crisp one hundred dollar bill for every occasion where I walked into a company that couldn’t make its impending payroll, but the controller, who extolled his several years of public accounting experience, insisted that the company was profitable on an EBITDA basis as if that mattered, I’d have many, many crisp hundred dollar bills.
You see, that positive EBITDA doesn’t reflect that, being June, our retail store has to start ordering for the holiday season, which means cash is going to be tied up in inventory. This means that the company is going to need cash – which it doesn’t have. So either it has to borrow more (which will increase debt service costs if there is even more money available for the company to borrow), or it has to use what cash it has and do what we in the turnaround and restructuring trade call “building a war-chest” and what our esteemed colleagues in the credit community refer to as “stretching payables” and later call “getting screwed.” Whichever way you choose to call it, EBITDA just doesn’t reflect changes in working capital requirements. Working capital is cash and, as we will see time and again, cash is king.
EBITDA Doesn’t Adhere to GAAP
Remember that controller with the years and years of public accounting experience, wherein I’m sure he or she might have come across the term “GAAP”? If Generally Accepted Accounting Principles are the hallmark of transparency and consistency in financial reporting, then EBITDA is the funhouse Hall of Mirrors. Because EBITDA is essentially a tool that shows what a company would look like if it wasn’t actually that company, (“Let’s see what this tax-paying, debt-ridden, asset-heavy company looks like without any debt, without tax burden, without assets and with no working capital needs!”) it is easily manipulated. Shocking, I know. And wait, there’s more – EBITDA provides no consistency check for a company’s accounting practices as to how it arrives at its cash-flow reporting.
For example, I worked as a restructuring advisor on a case about ten years ago where some of the related warehousing operations (which were not my client) reported EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization and Rent). We joked that, when you’re running an operation that is primarily real estate, the one thing that you’re going to have in abundance is rent. So why exclude one of your principal operating expenses? I’ve seen this used often in retail operations as well – take a large, undeniable expense category and turn it into a positive, by choosing to report it in a manner that artificially inflates cash. What’s next – EBITDARE (EBITDAR, plus all other Expenses)? I’m sure if we go through the exercise, we’ll find that even the most underperforming company will look great on EBITDA once we add back all of its expenses.
Finally, Some Really Smart People Looked at EBITDA, Looked at Some Actual Incidents, and said, “I told you so!” Because EBITDA Can Present a Whole Laundry List of Bad Information
In 2000, Moody’s Investors Services released a report titled: “Ten Critical Failings of EBITDA as the Principal Determinant of Cash Flow.” Personally, I think you have to start questioning the validity of a reporting measure somewhere after two or three failings (or even only one failing, especially when that failing is that EBITDA isn’t a determinant of cash flow at all). But, the insightful and detailed nice people at Moody’s gave unto us ten reasons, and that’s a good reason why their report is widely respected and oft-cited and why I’m just a turnaround and restructuring guy and a blogger.
But back to the point: Summarizing what may be the most glaring example of how EBITDA is (mis)used, the Moody’s report, as well as countless others, stated that those who use EBITDA as the sole basis for determination of a transaction multiple are likely deserving of the results they get. While EBITDA multiples are one of many transaction multiples to consider when calculating purchase price of a business, there are many better ones to use – particularly when EBITDA is so easily manipulated. Consider, for example, the story of a company whose value varied wildly depending upon which metric was used:
- Value based on top-line revenue: $5 million
- Value based on Gross Profit: $2.25 million
- Value based on EBITDA: $8.5 millionWho got the better deal if the GAAP-compliant metrics yielded values less than the non-GAAP-compliant metric? Then consider which buyer you want to be. Or, you could just pay based on EBITDA – I know a good turnaround guy when you need one.
And you’re going to need one.
As a parting thought, I offer you this: If a company is in a cash crisis, consider the following: if you take the earnings per share and multiply that by the company’s weighted average cost of capital, taking the result and multiplying it by the 360-day days sales outstanding, then you’re part of the problem because ratios aren’t doing a damn thing to stop the cash bleeding.
Ted Gavin, CTP is a managing director and founding partner of Gavin/Solmonese LLC, a national turnaround, restructuring and public affairs advisory firm and the successor to NHB Advisors, where he led the firm’s Bankruptcy & Fiduciary Services practices. He is a member of the Board of Directors of the American Bankruptcy Institute.