EBITDA is often used to make companies appear healthier than they are, but it has significant shortcomings as a performance measure. It ignores important expenses like depreciation, working capital needs, debt payments, and adherence to GAAP accounting standards. Relying solely on EBITDA can present an inaccurate picture of a company's true financial health and risk. It has been manipulated in many cases to inflate perceived value. Better metrics exist, like looking at revenue, gross profit, and cash flow more directly.

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Reasons why EBITDA can be a fallacy
By
Zubin Poonawalla
EBITDA, that widely-touted measure of company performance and
indicator of value otherwise known as earnings before interest, taxes,
depreciation, and amortization, is a fairy tale told to investors and
credit managers so that they go to sleep happy instead of running for
the hills. EBITDA purports to indicate a company’s pure operating
performance, free of such esoteric characteristics as debt cost, tax
burden, depreciation and amortization. In reality, EBITDA is akin to
a blender, into which go normal financial statements and out of
which comes a numberthat always seems to make the subject
company look better than it did when the numbers went into said
blender.
Let’s take a look at five reasons why relying on EBITDA means
buying into a great big lie.
#5 – EBITDA makes companies with asset-heavy balance sheets look
healthier than they may actually be.
Understanding the amount of asset depreciation is of limited value in
determining the present viability of a company; instead, it’s a
measure of what the company has spent, in the past, on capital
expenditures. For an owner or investor trying to evaluate the health
of a company in advance of their busy season, that knowledge plus
$1.29, will get them a medium cup of coffee at a local gas station

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convenience store. Depreciation and Amortization are “non-cash”
items – in other words, they are meaningless MacGuffins in the
context of a company’s fiscal health.
As we’ve discussed before, if there’s one thing that a company in
distress needs, it’s cash. Non-cash items are relegated to the
irrelevancy bin where they rest comfortably between the cultural
importance of the Jersey Shore season opener and Sarah Palin’s
opinion on the White House holiday card. Worse, this measure leaves
us blind as to the company’s future asset needs. That the company is
booking depreciation on hard assets is fine and good – but, as
Warren Buffet is credited as having said, “Does management think
the tooth fairy pays for capital expenditures?”
EBITDA leaves the viewer blind as to both short- and long-term asset
replacement needs – and those require cash, debt, or both.
#4 – EBITDA portrays a company’s debt service ability – but only
some types of debt.
EBITDA is a measure created by investment bankers to answer the
question “How much debt can a buyer put on this company after it’s
acquired?” And, for that EBITDA does a fine job, depending upon
which spot in the debt structure a creditor occupies. The type of debt
held by a given creditor may leave that creditor in a position that is
either advantageous or highly precarious. Consider a hypothetical
company that generates $10 Million in EBITDA this year –what this
doesn’t show is a hypothetical $12 Million of interest payments on its
senior secured credit facility that the company has to make between

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now and then. Simple math tells us that the company is now on the
wrong side of a $2 Million cash shortfall. Unless you’re the senior
secured lender and the EBITDA numberis in excess of your debt
service for the period projected, EBITDA is of little practical value.
3 – EBITDA ignores working capital requirements
Imagine you own a retail store chain, and it’s June. Like many retail
chains whose sales are holiday-concentrated, the company’s Year-to-
date EBITDA might be positive and its cash operations may be
flirting with breakeven, if not showing outright losses. “But, our
EBITDA is positive,” I hear this retail chain say. “How could anything
be wrong?”
Well, that positive EBITDA doesn’t reflect that, being June, our retail
store has to start ordering for the holiday season, which means cash
is going to be tied up in inventory. This means that the company is
going to need cash – which it doesn’t have. So either it has to borrow
more, which increases debt service costs, or it has to use what cash it
has and do what we in the restructuring community call “building a
war-chest” and what everyone in the trade credit community calls
“stretching payables” and later calls “getting screwed.” Either way
you choose to refer to it, EBITDA doesn’t reflect changes in working
capital requirements. Working capital is cash and, as I will mention
time and again, cash is king.
#2 – EBITDA doesn’t adhere to GAAP

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If Generally Accepted Accounting Principles are the hallmark of
transparency and consistency in financial reporting, then EBITDA is
the funhouse Hall of Mirrors. Because EBITDA is essentially a tool
that shows what a company would look like if it wasn’t actually that
company (“Let’s see what this tax-paying, debt-ridden, asset-heavy
company looks like without any debt, without tax burden, without
assets and with no working capital needs!”), it is easily manipulated.
And wait, there’s more – EBITDA doesn’t provide any consistency
check for a company’s accounting practices as to how it arrives at its
cash flow reporting.
For example, I worked as a restructuring advisor on a case about 10
years ago where some of the related warehousing operations (who
were not my client) reported EBITDAR (Earnings Before Interest,
Taxes, Depreciation, Amortization and Rent). We joked that, when
you’re running an operation which is primarily real estate, the one
thing that you have in abundance is Rent. So why exclude one of your
principal operating expenses? I’ve seen this usedoften in retail
operations as well – take a large, undeniable expense category and
turn it into a positive, by choosing to report it in a manner that
artificially inflates cash. What’s next – EBITDARE (EBITDAR, plus
all other Expenses)? I’m sure if we go through the exercise, we’ll find
that even the most underperforming company will look great on
EBITDA once we add back all of its expenses.
#1 – EBITDA can present a laundry list of bad information
In 2000, Moody’s Investors Services released a report titled “Ten
Critical Failings of EBITDA as the Principal Determinant of Cash

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Flow“ (free registration required). Personally, I think you only need
one failing – EBITDA isn’t a determinant of cash flow at all. But, the
folks at Moody’s, detail-oriented and insightful as they are, gave us
ten reasons, which is probably why their report is widely respected
and oft-cited and why I’m just a restructuring guy and a blogger. But
back to the point: Summarizing what may be the most glaring
example of how EBITDA is (mis)used, the Moody’s report, as well as
countless others, stated that those who use EBITDA as the sole basis
for determination of a transaction multiple are likely deserving of the
results they get. While EBITDA multiples are one of many
transaction multiples to consider when calculating purchase price of
a business, there are many better ones to use – particularly when
EBITDA is so easily manipulated. Consider, for example, the story of
a company whose value varied wildly depending upon which metric
was used:
 Value based on top-line revenue: $5 Million
 Value based on Gross Profit: $2.25 Million
 Value based on EBITDA: $8.5 Million
Who got the better deal if the GAAP-compliant metrics yield values
less than the non-GAAP-compliant metric? Then consider which
buyer you want to be. Or, you could just pay based on EBITDA!!!