Confusion Over EBITDA
The August 2008 issue of Mergers & Acquisition magazine contains an interesting article entitled Refining Ebitda. The sub-title is: “Who knew Ebitda had so many definitions? As deal pros, lenders and companies fight it out in negotiations, the earnings yardstick often gets distorted.”
So, the headline says EBITDA is a measure of earnings—simple enough. But then the confusion about this acronym for Earnings Before Interest, Taxes, Depreciation and Amortization reveals itself in the opening sentence: “Ebitda is used as a measure of a company’s cash flow and is instrumental in designing covenants for debt and profitability.”
In that single simple sentence, the author captures the confusion between earnings and cash flow, and illustrates the desperate need to standardize the definition of terms that are used daily within the M&A and corporate finance universe.
There is no need to define, redefine or modify the definition of EBITDA. The term is not a measure of cash flow. The term is a hybrid, a creation of the leveraged buyout world.
In a prior article entitled Forget About EBITDA, we pointed out that the term “gained prominence within the LBO community during the 1980s because it represented the gross dollars that could be made available to service acquisition debt. At that time, EBITDA was more relevant because the deal criteria of the typical LBO sponsor excluded companies that required significant investment for capital expenditures, research and development, or inventory. Less re-investment in the company meant that a larger portion of the EBITDA was available to service acquisition debt.”
At present, EBITDA is important to the investment banking and M&A communities for several reasons:
- Purchase prices are often expressed as multiples of EBITDA. At an M&A networking event, it is not uncommon to meet Business Development associates of private equity groups indicating their preference for deals in the range of X or Y times EBITDA.
- Purchase price comparables used to value or price a business are often made on the basis of EBITDA. The Guideline Company or Comparable Company Sales are valuation methods commonly used in the market valuation approach. In this case, the analyst first obtains transaction data for the subject company’s industry and similar firms. The transaction data is usually expressed as multiples of one or more base numbers including book value, revenues, assets, after-tax earnings, cash flow or EBITDA. The most appropriate base number and multiple are selected. EBITDA is often selected as a base number.
- EBITDA and its application in estimating value and purchase price in small business transactions is deeply ingrained because of the limited availability and quality of financial statement data. Sometimes the information needed to prepare a reliable cash flow statement is not available.
- In the process of underwriting M&A financing, lenders will use multiples of EBITDA as a quick way of determining the amount they will loan on a given deal. Multiples of EBITDA are used to evaluate the firm’s ability to cover principle and interest (P/I) payments. A “high” coverage multiple generally implies a higher capacity to repay and less risk. Conversely, lower coverage implies less ability to repay and greater risk of default. The EBITDA-to-loan multiple will change based upon the credit market in general, a particular lender’s credit doctrine at any given time, and the perceived risk of the transaction. Less leverage generally translates to either lower purchase price multiples paid to sellers, larger equity investment by the buyer or a combination of both. The net effect is to increase the cost of capital and lower equity returns to investors, all other things being equal.
- Lenders can include the EBITDA to P/I coverage ratio in loan covenant agreements. The borrower is required to maintain certain predefined multiples. These types of covenants are known as Affirmative Covenants (requirements the borrower must affirm or satisfy throughout the term of the loan agreement) and failure to meet these requirements will result in a technical default which gives the lender certain remedies as provided for in the agreement.
The article in Merger & Acquisition magazine goes on to explain that lenders are exerting more effort to negotiate a definition of EBITDA that is acceptable given the specifics of the business. It is pointed out that “lenders may seek a stricter definition that requires more capital expenditures be factored in and taken out of the company’s cash flow consideration.”
What we have here is a blurring of the definitions for EBITDA and Cash Flow. The problem that the industry is encountering is not the definition of EBITDA. That term is crystal clear. The only variable in the calculation is the accuracy and timeliness of the recognition of income and booking of expenses.
Simply stated, the deal pros, funding sources and companies are using the wrong metric. Trying to modify or customize a definition to meet the needs of the moment may be expedient, but in the end it only serves to add unnecessary confusion—as captured by the author of the Merger & Acquisition magazine article.
The metric that the industry should be using is the amount of cash flows that are available to pay debt and equity holders. This metric would start with the After Tax Net Operating Income plus Non-Cash Charges such as depreciation and amortization, a number very similar to EBITDA. However, to stop here would be an error. Capital Expenditures and Changes in Working Capital need to be deducted. The net result is Free Cash Flow available to Total Invested Capital (FCF-TIC).
FCF available to Total Invested Capital measures the amount of cash flow available to pay debt and equity holders. See the accompanying table for the formula for calculating FCF-TIC as well as the formula for Free Cash Flow available to Equity.
While the effort that goes into calculating FCF-TIC is greater than the effort that goes into EBITDA, the metric is far more meaningful. FCF-TIC can be calculated based upon historic, normalized and projected financial statement data.
MoneySoft is an advocate of Free Cash Flow and it is used extensively in our deal analysis software. We would like to see this more reliable metric come to replace or supplement the ubiquitous EBITDA. EBITDA may have out lived its usefulness.
In closing, there is a story about a young girl who is watching her mother prepare a roast for Sunday dinner. The girl observes that her mother cuts off both ends of the roast before placing in the pan and oven. “Why do you trim the ends of the roast,” she asks. The mother replies: “I don’t know why…it’s just the way my mother prepared the roast.” Now curious, the mother calls her mother and asks the very same question and gets the same answer: “I don’t know why…that’s just the way I learned to do it watching my mother.” Fortunately, the little girl’s great grandmother is still alive. When asked for the reason why she trimmed the ends of the roast, she replies: “Oh yes, back when you were a little girl, we only had one roasting pan and it was too small, so I would trim the roast to make it fit.”
So, to follow the metaphor, we now have a bigger and better roasting pan known as Free Cash Flow available to Total Invested Capital. It’s time that we stop trying bend the definition of EBITDA to fit our needs and start using Free Cash Flow as the preferred metric for loan advance rates, covenants and pricing multiples. It improves analysis and focuses negotiations on the coin of the deal makers’ realm: available cash flow.