EBTIDA should be used in context with additional financial data
By Michael French, CPA, ABV, CFE, Managing Director
As a metric indicating the financial health of a company, EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization – is heavily relied upon by buyers in the merger and acquisition process.
But while a company’s EBITDA analysis yields important information about the attractiveness of a potential acquisition, this metric does have shortcomings that should be recognized and mitigated to provide a full, accurate picture of the company’s strength.
What EBITDA Does Well
The use of EBITDA rose in the 1980s to help determine if a corporation could repay the interest associated with restructuring. Today, its use has evolved:
- Banks use EBITDA to calculate a company’s debt service coverage ratio, a debt-to-income measurement that assesses borrowing capacity and cash flow for business loans.
- Investors and business owners use EBITDA to compare companies within the same sectors, utilizing standardized sector averages.
- EBITDA sometimes is used to describe a company’s performance in general, particularly by observers who believe the EBITDA formula provides the clearest picture of performance and forward-looking potential.
- EBITDA also is used with other financial metrics to create insightful data, such as net debt-to-EBITDA ratios and EBITDA-to-sales ratios. Used in combination with other ratios, these metrics can show the trajectory of a company’s financial health.
Where EBITDA Is Weak
EBITDA is not recognized by GAAP (Generally Accepted Accounting Principles), meaning methods of reporting EBITDA can vary significantly from one company to another. Varying methodology among companies diminishes the reliability of EBITDA as a comparative tool. In addition:
- Different companies may utilize different earnings calculations as the base number to compute their EBITDA. However, even after eliminating distortions caused by interest, taxes, depreciation and amortization, the precision of the outcomes generated by EBITDA is determined by the accounting techniques used to calculate the earnings as declared on the income statement.
- EBITDA can make a company appear less expensive than it actually is. Producing value-price multiples on EBITDA only may not provide the full picture of value.
- Depreciation and EBITDA amortization are not considered actual expenses when evaluating a company’s financial performance. By not taking depreciation and amortization into account, EBITDA may make it appear that more funds are available for funding any capital expenditures that may be required.
- Working capital is not considered by EBITDA, though it is critical to dealing with receivables and inventory.
Mitigating EBITDA’s Shortcomings
EBITDA is an important metric to use to evaluate a company’s financial health, but it is an incomplete analysis that should be used in context with additional financial data, enabling buyers to achieve a more realistic picture of a target company’s financial performance.
For more information about the role of EBITDA in a transaction you may be contemplating, contact your PKF Advisory team member or:
Michael French, CPA, ABV, CFE