Get­ting to grips with ebitda

What is ebitda? What can it be used for? And un­der which cir­cum­stances should this num­ber be viewed with cau­tion?

Finweek English Edition - - MARKET PLACE - Ed­i­to­rial@fin­

the­fi­nan­cial in­dus­try is one char­ac­terised by mas­sive amounts of jar­gon and one of these terms is ebitda. It gets used in iso­la­tion but also in ra­tios such as debtto-ebitda and ebitda mar­gin. But what is ebitda?

What ex­actly is it?

To break down the acro­nym, it is earn­ings be­fore in­ter­est, tax, de­pre­ci­a­tion and amor­ti­sa­tion. The earn­ings fig­ure in­di­cates just that – in­come less di­rect costs and usu­ally called net in­come. In­ter­est is in­ter­est be­ing paid on debt, in a few very rare cases it may be in­ter­est re­ceived but for pretty much all listed com­pa­nies net in­ter­est is a pay­ment as debt is larger than cash hold­ings. Tax is tax be­ing paid to Sars or tax au­thor­i­ties in any other coun­try they op­er­ate in. De­pre­ci­a­tion is the write-down of tan­gi­ble as­sets such as equip­ment, while amor­ti­sa­tion is the write-down of in­tan­gi­ble as­sets such as good­will.

Ebitda is sup­posed to be a good, clear snap­shot of the things that a com­pany con­trols at the op­er­a­tional level. In a sense, it in­di­cates real profit be­fore all the nas­ties of tax, debt pay­ments and write-downs.

What to use it for

I do like it for that pur­pose, al­though there are some very large draw­backs that I will dis­cuss shortly. Where it can be use­ful is when one com­pares two very sim­i­lar com­pa­nies at their op­er­a­tional lev­els and then looks at the var­i­ous ra­tios. This gives a clear way to see how the two stack up against each other. It also helps us get an un­der­stand­ing of the dif­fer­ences be­tween in­dus­tries. For ex­am­ple, by looking at av­er­age ebitda ra­tios in health­care ver­sus re­tail, we can check if there are trends that in­di­cate that the one in­dus­try is more prof­itable than the other on av­er­age.

It also works very well for com­par­ing small com­pa­nies against much larger com­pa­nies when used as a ra­tio.

In truth, this is the case with most ra­tios and why we usu­ally turn to ra­tios rather than ab­so­lute num­bers.

But be care­ful…

The risks as­so­ci­ated with us­ing ebitda to judge a com­pany’s per­for­mance are in­ter­est and write­downs. A com­pany loaded with debt could have great ebitda growth and mar­gins but the debt pile and the cost of that debt could be killing it, so I al­ways want to also look at the ebitda-to-debt ra­tio as well as hav­ing a thor­ough look at the over­all debt sit­u­a­tion. Write-downs are an­other is­sue. Be they tan­gi­ble or in­tan­gi­ble, write-downs are of­ten merely glanced over, but they are as­sets that have been paid for and so writ­ing them down means the com­pany is out of pocket and the as­set side of the bal­ance sheet is worse off be­cause of the write-down. Tan­gi­ble equip­ment has a fi­nite life span, for ex­am­ple a truck used in the busi­ness does not last for­ever. As a result, ac­count­ing stan­dards al­low for these as­sets to be writ­ten down to zero value af­ter a de­fined pe­riod when they no longer have value and likely no longer have any use. An­other is­sue is that a pos­i­tive ebitda fig­ure does not mean a com­pany gen­er­ates cash and in fact this term ar­rived dur­ing the dot-com era when pos­i­tive cash flow was a dream for the hot stocks of the day. The re­al­ity is that equip­ment needs to be re­placed, work­ing cap­i­tal may need to be in­creased and none of this is seen within ebitda. Warren Buf­fett asked: “Does man­age­ment think the tooth fairy pays for cap­i­tal ex­pen­di­tures?” and it’s a fair ques­tion. Fur­ther, since ebitda is not an of­fi­cial reg­u­lated ac­count­ing term as de­fined by In­ter­na­tional Fi­nan­cial Re­port­ing Stan­dards (IFRS) or Gen­er­ally Ac­cepted Ac­count­ing Prin­ci­ples (GAAP), we’re not al­ways com­par­ing like with like. To sum up, while ebitda can be use­ful, I gen­er­ally view it with a scep­ti­cal eye and pre­fer es­tab­lished IFRS num­bers.

Where it can be use­ful is when one com­pares two very sim­i­lar com­pa­nies at their op­er­a­tional lev­els and then looks at the var­i­ous ra­tios.

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