Amortization of goodwill is thus a charge that does not necessarily reflect a real decline in economic value and that likely not be spent in the future to preserve the business. Charges for goodwill amortization usually do represent free cash flow.
Either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.
In fact, many leveraged takeovers of the s forecast steadily rising cash flows resulting partly from anticipated sharp reductions in capital expenditures. Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.
Businesses invest in physical plant and equipment for many reasons: to remain in business, to compete, to grow, and to diversify. Expenditures to stay in business and to compete are absolutely necessary. Capital expenditures required for growth are important but not usually essential, while expenditures made for diversification are often not necessary at all.
Identifying the necessary expenditures requires intimate knowledge of a company, information typically available only to insiders. Since detailed capital-spending information was not readily available to investors, perhaps they simply chose to disregard it.
Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because all the capital expenditures of a business could be financed externally through lease financing, equipment trusts, nonrecourse debt, etc. One hundred percent of EBITDA would thus be free pre-tax cash flow available to service debt; no money would be required for reinvestment in the business. This view was flawed, of course. Leasehold improvements and parts of a machine are not typically financeable for any company.
Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose.
An overleveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation. EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time.
Without the high-priced takeovers there were no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios.
This would not be the first time on Wall Street that the means were adapted to justify an end. If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard. EBITDA, in addition to being a flawed measure of cash flow, also masks the relative importance of the several components of corporate cash flow.
Notify me of follow-up comments by email. Notify me of new posts by email. Chris Mercer Menu Skip to content. It is nowhere to be found on audited financial statements.
Then one can compare that amount with other companies. One could also look at the balance sheet. One can analyze EBITDA until the cows come home and never learn how much working capital a company will need in the next period, or should have had in the current period.
I like to look at the balance sheet and cash flow statement to begin to assess working capital needs, so I never expected EBITDA to inform me about working capital. Others apparently do. That DA can give a glimmer of current and future needs, especially when examined in light of capex showing on the cash flow statement. Consider, for example, the story of a company whose value varied wildly depending upon which metric was used:.
Then consider which buyer you want to be. Until my next post, I leave you with these entries from my growing list of Irreverent Turnaround Tips…. This is a BETA experience. Consider a US defense contractor, there are several restrictions on the domicile of service provider and in some cases, the contracts are restricted exclusively for US incorporated businesses and hence, the company would be subject to federal and state tax laws if it has to continue to do business with the department of defense.
Consider many large US headquartered international companies and you will find a large difference between applicable tax rates and cash tax payments. The difference is not only due to these companies holding cash in international jurisdictions e.
This also make a standardized approach to taxes difficult to implement and EBITDA takes the shortcut and very conveniently skips all of this. EBITDA was conceived of as a way to more clearly measure operational performance of a company by excluding expenses that can obscure the true performance of the business.
In some industries, the very expenses that EBITDA ignores are in fact operational expenses required in the day-to-day operations of the company. The often questionable nature of the metric which had for many years either been ignored or misunderstood was suddenly thrown into the limelight. As Daniel Gross of Slate recounted :. Chief financial officers could routinely manage earnings by using the tremendous leeway that existed to account for certain items or take various charges.
But EBITDA had far fewer moving parts, and there was far less discretion in accounting for items like operating expenses and revenues. This is particularly true for small businesses where most of the business is done on a cash basis and both revenues and operating expenses in the financial statements represent an almost complete picture of the business during a particular year.
Take the case of La-Z-Boy, the eponymous recliner company. Chris Higson of London Business School elaborates on this point:. After all, taking the raw transactional data and pushing it around between periods using judgments about accruals is what accountants do. The cash flow statement simply undoes these accruals. Unfortunately, the general view that cash flow is robust to accounting choices is, at best, only partly true and the specific view about EBITDA is wrong.
Accrual accounting gets reversed at different points through the cash flow statement so, in general, cash flow statements get more robust to the effects of accounting policy choice the further down the page you go.
For example, revenue anticipation is reversed in working capital investment, cost capitalisation is reversed in capex. EBITDA is at the top of the cash flow statement and it is the cash flow measure that is most vulnerable to accounting. As Dr. Higson described above, the fact that EBITDA sits at the top of the cash flow statement by definition means that significant cash flow expenses are not included in its calculation.
Businesses with high working capital requirements for instance would not see the effects of this reflected in their EBITDA figures. Returning to our previous example of Sprint, if we compare the EBITDA numbers with the free cash flow numbers, we can again see a hugely different picture.
Considering the above, we can conclude that although Sprint looked like a good business at the EBITDA level, it becomes a highly unsustainable business when we look at other profitability metrics such as EBIT, net income, and free cash flows—so much so that Sprint is currently on the verge of bankruptcy with c.
Restaurant Brands International would be paying top dollar to acquire Popeyes raised some eyebrows. He believes that EBITDA might have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time s.
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