The EBITDA fallacy

Securities regulators in Canada and the U.S. are taking a harder line on non-GAAP disclosures and this columnist agrees, calling for an “old school” approach where profit and cash flow reflect reality
By John Caldwell

The photo of the individual who concocted the concept of EBITDA should be prominently displayed on a wall of shame in every commercial centre worldwide.

EBITDA, in case you’ve forgotten, is short for Earnings Before Interest, Taxes, Depreciation and Amortization. It has been widely used as a financial measure for decades, supposedly to synthetically represent cash flow. Nothing could be further from the truth. The only seemingly redeeming benefits of EBITDA are ease of calculation and allowing company comparisons by eliminating the effect of differing capital and taxation structures.

To illustrate the fallacy of using EBITA as a proxy for cash flow, let’s consider the 2016 results of a large telecommunication company. In this year, it reported EBITDA of $4.180 billion. Yet in 2016, its cash balance actually declined by $82 million—roughly just a $4.3-billion difference.

This difference arises from a combination of interest and a portion of taxes that are paid in cash as well as changes in working capital, capital expenditures, investments, dividends and the repayment of debt.

EBITDA is hardly a proxy for cash flow. Rather it is a form of an adjusted earnings calculation.

Businesses are often valued using EBITDA multiples. In our example here, this company currently is valued at about 10 times EBITDA. To put this in perspective, based upon 2016 performance, excluding dividends and debt repayment, it would take investors not 10 years, but actually almost 30 years to recover their investment.

Importantly, EBITDA valuations make no distinction between capital-intensive businesses or those with differing working capital requirements.

The punch line is EBITDA cannot be deposited, spent or distributed to shareholders. Only cash can. Puzzlingly, EBITDA is now a customary term used in commercial loan covenants.

Warren Buffett once stated in a letter to Berkshire Hathaway shareholders: “References to EBITDA make us shudder—does management think that the tooth fairy pays for capital expenditures?”

Years ago, financial analysts often made adjustments to companies’ earnings to remove unusual items such as the write down of an asset value so they could make more accurate comparisons of representative annual results. But adjusted earnings has now taken on a whole new meaning. Virtually every company discloses some form of adjusted earnings, almost without exception showing better so-called bottom-line results. It is common for companies to provide adjusted earnings data that excludes restructuring charges, amortization of acquisition-related intangible assets, equity-based compensation as well as litigation settlements. On the concept of adjusted earnings, again Buffet perhaps said it best: “If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”

It is hardly surprising securities regulators on both sides of the 49th parallel are taking a harder line on non-GAAP disclosures, insisting among other things that GAAP results must carry equal or greater prominence.

Over-emphasis or reliance of non-GAAP measures can at best be misleading and there are several risks associated with a preoccupation with the overuse of non-GAAP measures. Flawed decision-making is at the top of the list. For example, using EBITDA for acquisition valuation inflates and distorts purchase prices such that cash-based returns can be meagre at best. Similarly, I have witnessed firsthand in a distressed situation that tying compensation to EBITDA targets can result in diverting attention and control of debt levels, taxation, working capital and capital expenditures—all-important outflows of cash.

Here is a novel idea: Let’s revert to an old-school approach where profits are calculated using standard accounting conventions and the focus is on the true (after-tax) bottom line and cash flow really means the bank balance difference between the start and the end of the period.

John Caldwell is a veteran CEO and board member experienced in distressed situations and is the author of CPA Canada’s A Framework for Board Oversight of Enterprise Risk. E-mail:

Print Friendly
This entry was posted in Views and tagged , , , , . Bookmark the permalink.

Comments are closed.