Adjusted EBITDA: So much more yet so much less

Dev Strischek, Principal, Devon Risk Advisory Group


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Why are calculating minds so invested in EBITDA and its puffier version adjusted EBITDA? First, with a little legerdemain, clever hands replace operating cash flow with EBITDA as their starting point in conjuring proof of repayment ability. The next magical stretch of the imagination occurs as these wizards rationalize other expenses outside the operating budget into so-called non-recurring, extraordinary, non-operating costs under the illusion that these items will not occur again when the company settles back down to its normal, day-to-day operations. Imaginative analysts call these fanciful steps “normalization” as they drift deeper into financial fantasy to remove all this non-recurring expense or revenue stuff from a financial metric like EBITDA, EBIT or even earnings. Then, to perpetuate the dream, analysts often use a three-year or five-year average adjusted EBITDA to smooth out the fluffy data some more. Once earnings have been pleasingly normalized and smoothed, the resulting groomed and manicured number purportedly represents the future earnings capacity that an investor or owner or lender can expect from the business. But wait—if plain Jane EBITDA doesn’t spell cash flow, how can cosmetically enhanced adjusted EBITDA be any better looking?

Normalcy is the new normal

The possible adjustments to EBITDA can vary widely from industry to industry and company to company. But a list of five commonly adjusted items include:

  1. Owner salaries and bonuses are often higher or lower than the norm. Adjustments for reasonable compensation are defined by Treasury Regulation 1.162-7(b)(3) as: “the amount that would ordinarily be paid for like services by like organizations in like circumstances.” Business owners often draw larger-than-usual salaries for tax purposes and sometimes they take smaller salaries to boost reported earnings. To help develop a realistic picture of available earnings, appraisers adjust owner’s compensation to remove “owner bias” to better reflects the true financial performance in the hands of a hypothetical prospective buyer inherent in the definition of fair market value.
  2. Rent paid to a related entity that owns the business is often greater than the going market rent. In the case of above market rents, EBITDA is increased when adjusting rent to market rates. Below market rent would be an adjustment to decrease EBITDA.
  3. Sales or expenses that are not at an arm’s-length transaction. Examples might be related entities selling to each other at marked-up rates and/or cross use of employees.
  4. Non-recurring income and expenses, e.g., one-time start-up costs, legal and/or professional fees to organize or defend the business in litigation.
  5. Repairs and maintenance because owners may aggressively expense capital assets which should be capitalized and depreciated over time on the balance sheet.

Mind the GAAP

The SEC requires publicly traded companies to file financial statements in accordance with accrual accounting rules called Generally Accepted Accounting Principles (GAAP), and bankers also prefer audited financials from their borrowers. EBITDA is a common “non-GAAP” profitability metric.   The idea behind EBITDA is to give analysts a way to compare profitability across companies irrespective of leverage, hence the removal of interest expense, taxes where various deductions and different jurisdictions can distort seeing “core operating performance”, and D&A. One of the appeals of EBITDA is that no standard applies to EBITDA because it is non-GAAP. Therefore, firms can publish “adjusted EBITDA” figures that remove a variety of expenses from net income and growing adjusted EBITDA results. The companies insist they are not hiding anything—the net income and adjustment detail is all there—these disclosures are just supplementing to GAAP results, and many analysts, investors, lenders, and creditors often just accept this pretty data without sufficient scrutiny. It is testimony to the observation that beauty is only skin deep.

Adjusted EBITDA still doesn’t spell cash flow

Casual Googling of adjusted EBITDA reveals numerous sites that offer models that calculate EBITDA and adjust it accordingly, but their basic fallacy is that they ignore EBITDA’s fundamental weakness—it simply does not measure cash flow. EBITDA ignores a company’s tax obligation, which is a cash-absorbing expense. It assumes that fixed assets don’t require CAPEX replenishment, a stretch of credulity for fast-growing firms. It overlooks the working capital requirements for more inventory and accounts receivable to support growing sales. Public companies are often committed to maintaining a steady record of declaring and paying dividends in order to have access to public debt and equity markets, so interruption of dividend payouts may shrink company market values.

Closing and summary: What to do?

Let’s try to break EBITDA’s spell. First, stop relying on EBITDA as a cash flow measure. Second, either rely on the GAAP cash flow statement or convert EBITDA to free cash flow (FCF). The smart investors like Warren Buffett already do this. You can always Google FCF for instruction, but its primary advantage is that by starting with EBITDA, considering working capital investment to calculate operating cash flow, and then deducting fixed asset investment and existing debt service requirements to estimate cash flow available for new debt exposes just how little is left for the new kids on the bank block. As the futurist Alvin Toffler noted, “Profits, like sausages, are esteemed by people who know the least about what goes into them.” Before you swallow any more EBITDA, think about all the adjusted filler that’s been stuffed into it. Go for the leaner choice, operating cash flow or free cash flow. You will enjoy better financial health.

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