Is It Time to Get Rid of EBITDA?

After facing a daily barrage of news stories about alleged abuse by corporations, officers, and the accountants who are supposed to certify the validity of their statements, a weary public could be forgiven for wondering if the well of accounting and financial controversies has finally run dry.

According to Wharton faculty and other experts, not yet. The latest target, however, may not be a company or even an individual. Instead it is a concept, EBITDA, that may have been indirectly responsible for at least some of the corporate carcasses now littering the landscape.

EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, has been used by analysts and investors as a tool to measure the fiscal health of the many high tech, media and other asset-heavy firms that do not generate earnings, but instead incur plenty of depreciation, amortization, and other charges.

In the 1980s through the 1990s, many analysts and others believed that peeling away these expenses, which generally were not directly incurred in operations, would enable them to more accurately analyze and compare the  core operations of companies. In fact, many treated EBITDA as a modified  cash flow statement, sometimes mistakenly referring to it as  free cash flow.

It should be noted, though, that while a cash flow statement reconciles a company s net income or loss for a period to the company s cash position as of the end of that period, EBITDA does not. EBITDA is also different from a  free cash flow statement, which is basically EBITDA reduced by capital expenditures (purchases of generally long-lived assets like machinery, equipment or other items that show up on the balance sheet instead of the income statement). And of course, because EBITDA excludes so many expenses, it does not measure net income. In light of this, some people have questioned its usefulness.

John Percival, an adjunct finance professor at Wharton, is one who never quite accepted EBITDA as a valid tool.  In some of my classes, I call it EBIT Duh, he says.  It is the lazy analyst s cash flow and it is dangerous.

Other accountants are also raising issues about EBITDA. Ben Neuhausen, the national director of accounting at BDO Seidman, notes that  EBITDA continues to be valuable. But it needs to be used with care. As a measure of performance it is not a substitute for net income. Just as EBITDA ignores cash outlays for capital expenditures that can be significant, it also ignores interest and other specified expenses that can account for a large part of a company s cash outflow.

EBITDA, Percival says, was originally used to assess the ability of a company to service its debt in the short run, about a year or two. Comparing EBITDA to interest expense would theoretically give a user an idea about whether there was sufficient operating income to meet interest payments. But because it ignored many sources of cash outflow (such as capital expenditures), a company could turn in stellar EBITDA, yet not have enough cash on hand to fund its interest and other payments. The problem was actually exacerbated in the 1980s when leveraged buyouts (LBOs), which typically incurred high levels of debt, began to sweep across the nation.

 In the 1980 s people started to use EBITDA to find good candidates for LBOs, (EBITDA was thought to be a good indicator of a company s ability to meet debt payments), says Percival.  They would project growing EBITDA in the future and say that the company could handle much more debt. Using an EBITDA-based analysis, says Percival, LBOs would then put  huge amounts of debt in companies and then later find that there was not sufficient cash to service the debt.

But he notes that EBITDA makes some shaky assumptions, such as a presumption that all revenues are collected. It is  ludicrous, he adds, to use EBITDA to value companies. The problem, according to Percival, is that company value is really an equity concept,  and equity value comes from future free cash flow. Because it doesn t consider capital-intensive and other cash expenditures,  EBITDA is a poor approximation to free cash flow Overall, except for very specific, limited applications, EBITDA is a dangerous number.

That was clearly demonstrated in the case of WorldCom, which saw its stock go into a free-fall and was recently delisted after the company reported that it had inflated its EBITDA by $3.8 billion over a five-quarter period by simply, and improperly, classifying routine operating costs as long-term capital costs.

Operating costs and other expenses should generally be immediately recognized in the period incurred unlike expenditures that can legitimately be capitalized as assets and depreciated over their useful life. By misrepresenting these expenses, WorldCom artificially inflated its net income and, therefore, its EBITDA.

If the company believed there was justification for treating these expenses as capital expenditures, that rationalization should have been disclosed through financial statement footnotes or other appropriate means.

Former WorldCom CFO Scott Sullivan recently pled not guilty to charges of securities fraud. A recent tally of the company s accounting errors (including revenue misstatement and the improper deconsolidation of an unprofitable subsidiary) now stands at an estimated $10 billion, according to CFO.com.

Percival s skeptical view of EBITDA is today echoed, in varying degrees, by a wide range of professionals on Wall Street and beyond. One critic is Jordan Rohan, a principal at SoundView Technology Group, who covers media and entertainment, cable, and online media sectors.  While EBITDA used to be a key valuation method of media, it is being displaced by one that incorporates price-to-earnings and price-to-sales multiples, EBITDA and cash flow analysis, he says.

Earlier this year, for example, after he recalculated the companies earnings projections under GAAP instead of EBITDA, Rohan reduced his price target on four media stocks: Clear Channel Communications; AOL Time Warner, Inc. (which is now under investigation by the SEC for allegedly inappropriately recognizing income from transactions involving its AOL unit and third parties); Walt Disney Co., and Viacom, Inc. He cautions, though, that such projections  are constantly in motion.

Caveats about EBITDA are even being issued from accounting s standard setters, although the warnings stop short of a disavowal. For example, in an August 2001 project proposal titled  Reporting Information About The Financial Performance Of Business Enterprises, the Financial Accounting Standards Board (FASB) noted its concern that while many companies increasingly focus on alternative measures of performance, including EBITDA,  …the current use of alternative and inconsistent measures is often confusing and sometimes misleading. That project, now called  Financial Performance Reporting by Business Enterprises is currently in process.

Like Percival, Neuhausen says EBITDA s original attraction may be traced to the high volume of LBOs of the 1980s. The structure of those LBOs meant that most were accounted for under the Purchase method of accounting (as opposed to the Pooling-of-Interest method, which was later effectively eliminated by FASB). Under the purchase method, assets acquired in a business combination are generally recorded by the acquirer at its fair market value, which may be significantly higher than book value.

 Because purchase accounting resulted in a step-up of asset values, it also triggered higher depreciation expense, explains Neuhausen.  EBITDA was viewed as a way to compare a company s performance before and after an LBO; and was also seen as a way to compare LBO companies with non-leveraged ones. But expenses associated with debt service are real costs and cannot be ignored. EBITDA may be useful in a limited context if it s utilized in concert with other measures.

EBITDA does have its defenders, however. Accounting professor Cathy Schrand points out that EBITDA provides a measure of the performance of a company, regardless of how it was financed. She agrees that EBITDA ignores such financing costs as interest, but counters that other metrics, like net income, do not consider other issues, such as the cost of dividends that may be incurred when stock is issued.

 There are also intangible costs related to the issuance of stock, such as the dilution of shareholders ownership interest, she says.  EBITDA or other measures may be appropriate, depending on what is being examined. For example, interest is a cost of funding, and reflects one choice of financing. So if the overall performance of a company, including its choices about financing, is being studied, then a measurement that considers earnings after interest might be appropriate.

Financial analytical tools are constantly being developed and refined. But just as physicists and other scientists are still searching for a Unified Theory to explain all the basic forces of physics, financial and accounting professionals have yet to discover a unified theory to analyze a company s performance. And as the recent experiences with EBITDA demonstrate, until such a unified theory is developed, it can be dangerous to place too much reliance on any single analytical tool.