Earnings before interest, taxes, depreciation, and amortisation (EBITDA) are financial figures that show an entity's profitability, excluding depreciation, amortisation, interest, and taxes. EBITDA is also known as PBITDA (when the term profit is used rather than earnings).
Although the use of EBITDA might not be wrong in some cases, it does not comply with Generally Accepted Accounting Principles (GAAP). Therefore, the fear of it is the beginning of corporate financial wisdom. But why is that? Let us explain it in this article.
Failure to comply with GAAP
EBITDA does not comply with GAAP. US-GAAP and IFRS accounting standards are established for a reason. Excluding depreciation and amortisation when determining a company's corporate financial health means failing to comply completely with GAAP. Using EBITDA becomes an outlier. A lack of caution may cause a company to fall into a dip hole.
To illustrate, depreciation is a capital expenditure item. The assets were brought with cash by the company. This involved a huge cash movement, and if recorded in full at the time of purchase, it would result in higher losses now. Although the assets will be in use for more than one year.
To avoid this, the accrual accounting principle is applied. The asset is depreciated over a period of years. So that only a part of the cash spent is reported in the profit statement every year.
However, the use of EBITDA for these assets. Whereas, without them, production will not take place and revenue used in determining the above will not be available.
Easily manipulated by management
As EBITDA does not comply fully with GAAP, it can be manipulated by management. This implies that top management can decide what its PBITDA should be when sourcing for debt financing.
An example of this occurred in the United States during the dotcom bubble. Some companies' management manipulated their profitability. This makes them look good in public view.
Investopedia published that WeWork used community computed EBITDA during their initial public offering in 2018 excluding sales and marketing expenses, general and administrative expenses.
Users believe it can be used as a cash profit
EBITDA is a lazy way to compute cash profit. Instead of computing for free cash flow, PBITDA can be used as an alternative. It can also be used as an alternative to net operating cash flows. The value reveals to analysts that a company can pay the cost of debt financing.
But analysts using it do not realise that it contains accruals and prepayments. That is, income and expenses that are reported for the year but the actual cash has not been collected.
Therefore, using PBITDA as a measure of cash profit should be approached with caution. That is, by releasing it, it is limited. This is corporate financial wisdom.
Fails to recognise CAPEX
The use of EBITDA does not report capital expenditure (CAPEX). For example, a company may have huge costs for technological equipment and software. These costs should be recognised in profit computation through depreciation and amortisation. Doing so, will reflect the true and fair view of the company's profitability.
However, EBITDA failed to include CAPEX. As a result, it does not show the true picture of the entity's financial health.
Not a measure of market structure
In a social media platform, EBITDA was used to measure a company's market structure. Some say that because Dangite Cement Plc has a PBITDA of more than 50%, it signifies that the company is a monopoly.
A firm’s market structure is based on certain criteria as explained by economists. For example, there is a high cost of entry with a single seller, which means it is a monopoly market. If the same feature above exists, but there are a few sellers, it is called an oligopoly.
EBITDA does not explain why there is a high cost of entry nor determine the number of sellers in the market. Instead, it omits the high cost of entry, such as the cost of acquiring properties, plants and machinery.
Why does EBITDA still matter?
Despite its criticism, EBITDA measurement is useful in three situations.
When sourcing for debt financing
A good EBITDA makes it easy to access debt finance. PBITDA that doubles the interest cost of debt finance is acceptable to the lender.
For a startup's valuation
Small companies can use EBITDA for business valuation. Why? Startups may incur capital expenditure. The depreciation of the CAPEX will result in a loss before tax. So, investors use the PBITDA value to measure the profitability of a small company.
When a business is in survival mode
An existing business might incur losses for many years. But it may still be in business. Non-fashionable EBITDA may explain why.
The survival mode may be due to the high interest cost, depreciation, and amortisation. These are ignored in the computation of PBITDA. This implies that the company meets its yearly operational needs but cannot save for future growth and expansion.
To wrap it up, EBITDA does not fully comply with GAAP and might be subject to management manipulations. The value does not explain the company's market structure. More so, it is not an alternative to cash profit for capital budgeting decisions.
However, investors can use PBITDA for startup valuation. A lender can use the measure to determine if a company deserves debt funding. Users can make better decisions when they combine EBITDA with other financial metrics in analysing the financial health of a company.