Corner Office-It’s All About EBITDA (Duh!)
Many years ago, when I took a business finance class in college, our professor announced: “Today, class, we are going to talk about that dirty little word called EBITDA.” Being a rather naÃ¯ve kid from Lancaster County, Nebraska, I must say that I got a bit giddy about the prospects of this lecture, especially since a couple of cute cheerleaders were my class.
Well, it didn’t take long to figure out that this lecture had nothing to do with the thoughts that I had conjured up in my testosterone-driven imagination. The “dirty little word” my professor had referenced had to do with a company’s earnings before interest, taxes, depreciation, and amortization, or EBITDA.
Having been in business for almost 40 years now as a manager, executive, and owner, I have come to realize the significance of the insignificance assigned to this subject in that finance class. I’ve come to understand EBITDA as one of the most important metrics for measuring management’s performance, as well as a company’s true value.
While it may be hard to believe, the following statement is from a conversation that I had with a certified public accountant who was the financial manager at a troubled company with which my firm was consulting: “Look, I don’t know how we could be out of cash when our profit-and-loss statement shows us as having made a profit.” The company didn’t have enough cash to pay the bank the interest it owed, or to pay normal operating expenses, including payroll at the end of the week. Yet this accountant was in disbelief that his company was in dire straits because the profit-and-loss statement showed a profit.
Luckily, my professional instincts overruled my native instincts (I didn’t blurt out, “Look, you economic illiterate! Profit on a P&L doesn’t equal cash. It’s all about EBITDA, and your lack of understanding makes you an EBIT . . . fool!”) Instead, I patiently explained that the profit-and-loss statement is so full of Financial Accounting Standards Board rules, accruals, noncash charges such as depreciation and amortization, and other accounting padding that in the end, it really doesn’t tell you the amount of blood (cash flow) that is running through the veins of your company.
Cash Flow Is the Key Metric
EBITDA is the true measure of cash flow in a company. For those of you who like mathematical formulas, think about it like this:
EBITDA = Revenue – Expenses (excluding taxes, interest, depreciation, amortization).
In other words, EBITDA is the shorthand method for measuring operating cash flow and is the best measure of recurring value generation. It’s like watching your personal checkbook: You see what’s coming in, what’s going out, and what you need to operate in the near-term future.
Managing on the basis of EBITDA rather than the profit-and-loss statements eliminates the effects of financing, accounting rules, and all the other smoke and mirrors that look good on paper but get in the way of getting a real picture of the financial health of your company. If the accountant I mentioned previously had been measuring EBITDA in addition to profit, he would have been able to see the future trouble his company was heading toward well before it hit the wall.
Bear in mind that the “D” and “A” in EBITDA are non-cash expenses, so many companies just use EBIT to measure cash. It also leaves out items such as debt payments and other fixed expenses, cash required for working capital, and capital expenditures. I recognize that some people believe that a better method for measuring cash flow may be a free–cash flow model, which is simply cash from operations minus capital expenditures. Free cash flow captures the items EBITDA leaves out: receivables, inventory, and capital expenditures such as property and equipment. However, free cash flow doesn’t count the cost of debt either.
My point is not to debate the respective merits of the use of EBITDA, EBIT, free cash flow, or some other method. Rather, it is to drive home the fact that these metrics will be more accurate and meaningful to you than using profit-and-loss statements, which are not giving you the complete picture of your company’s health. Measuring the cash your company is generating will give you a better sense of the future state of your business before you have to pay creditors, Uncle Sam, et cetera.
Besides measuring cash flow, it is also critical that your company project its cash flow into the near future for about 13 weeks. I can’t begin to tell you how many companies do not have projected–cash flow statements. How can you possibly manage a business if you don’t know how much cash is coming in, how much you need to pay out, how much you have left over, or how much you need to borrow? If your company isn’t doing this on a rolling weekly basis, it seems like you are driving your corporate car with blinders on.
EBITDA and Valuation
While it’s true that EBITDA first came into common use in the 1980s, when investment bankers were searching for ways to predict whether or not a company had the ability to service its debt, it is useful for all business managers.
It became a tool for assigning a value to a business, especially in deals between companies in different industries. EBITDA can be used to analyze and compare profitability, because it strips away the non-comparables. So, if you want to increase the value of your business (to sell it, for example), focus on increasing the value of your EBITDA.
In the case of an unprofitable company, measuring EBITDA will make it easier to figure out which elements of the business need to be improved. It puts a spotlight on ways to help cash flow, such as improving gross profit margin, lowering the cost of goods sold, or taking expenses out of general and administrative areas, for example.
Historically, public companies focused management decisions on how actions impacted earnings per share. Nowadays, analysts are starting to realize the value of cash flow. In the case of nano-cap, micro-cap, and some small-cap companies that are not yet generating earnings because management is investing in the future of the firm, measuring EBITDA may not be the most appropriate measurement. Other key indicators include whether revenues are growing and gross profit margins are increasing. But it’s still important to track EBITDA and subtract the investment spending to understand if the core business is healthy.
A word of caution: While I am a strong proponent of EBITDA, it’s wise to be aware that EBITDA is a non-GAAP (Generally Accepted Accounting Principle) measure that allows a greater amount of discretion as to what is and is not included in its calculation. Companies can change the items they include from one reporting period to the next. So be sure that you understand those details.
Cash is the life blood of a company, so measuring cash flow is like monitoring your blood pressure. When my firm begins working with troubled companies, the first action item is to analyze EBITDA, and that’s how we know if we need a band-aid, emergency surgery, or something in between.
This may seem simplistic, but my experience is that too many executives and financial managers have been trained to focus on the profit-and-loss statement alone—and think that EBITDA is one of those investment- banking jargon words used to impress co-workers hanging around the water cooler. But in my vision of the perfect business, management would live by the mantra, “Duh, it’s all about EBITDA ,” and avoid becoming an EBITD . . . fool!