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The Flaws of EBITDA

Author: Administrator
Category: Accounting Services
The Flaws of EBITDA

A common way of measuring a company’s value and understanding its ability to pay back debt is by reviewing EBITDA (earnings before interest, taxes, depreciation and amortization). It’s calculated by taking net income and adding back interest, taxes, depreciation and amortization. You have probably read multiple articles describing EBITDA as a way to provide an “apples-to-apples” comparison of profitability between companies/industries. It accomplishes this by excluding the impact of financing (interest) and certain non-cash accounting items (think depreciation & amortization). Since EBITDA is so widely used, a company’s value is often referred to in multiples of EBITDA (Business Operational Value/EBITDA).

For as much as it is used in the financial world, EBITDA, by itself, does have its flaws. Cash is still king and while EBITDA is represented as a proxy for cash flow, it does not factor in significant costs to properly illustrate a company’s cash flow position. Companies and investors, alike, get themselves into dangerous territory when they start using EBITDA and cash flow interchangeably. The below bullets examine some of the flaws of EBITDA:

  • EBITDA does not capture capital expenditures. Asset heavy companies typically require a high level of capital expenditures in order to replace equipment and generate revenue. Cash is needed to fund these commitments and is a common oversight when relying solely on EBITDA as capital expenditures are put to the balance sheet and subsequently depreciated.
  • Not all taxes are created equally. Many taxes such as property taxes and franchise taxes are pegged to items other than earnings (such as revenue and asset value). These costs will continue regardless of the post transaction entity structure. Many times these items are included in the tax add back when they should not be.
  • In certain industries, such as those heavy in tooling and software development, internal labor and other costs may be capitalized. In other words, the recognition of the expense is delayed and recorded as a long-term asset. This results is overstated EBITDA relative to cash flow and removes costs from the income statement.
  • Companies and industries that collect cash in advance and defer revenue often experience a significant mismatch in cash and EBITDA. This can easily mask issues in the underlying cash flow.
  • Common expenses such as rent (for example if building is owned but will be leased post acquisition) and owners compensation (for example if owner is taking distributions from equity instead of a salary) are often missing from income statements, omitting substantial costs from the EBITDA calculation.

Need help bridging the gap between EBITDA and earnings reality?

When you engage Assure Professional for due diligence services we will perform a Quality of Earnings Analysis to help you understand a company’s true earnings position. This report is an extensive examination of a company’s revenue and expenses along with other qualitative and quantitative factors. Used in tandem with EBITDA, this will allow you to make the most informed decision regarding your acquisition.

Contact us for more information!

Chris Fameree, Managing Partner
(c) 704.351.5509

William Holman, Audit & Accounting Partner
(c) 865.661.6019

Doug Hayes, Tax Partner
(c) 704.460.7158
(888) 605-9848

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