“EBITDA”: Financial Expression of the Day

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EBITDA: Acronym, Earnings Before Interest, Taxes, Depreciation, and Amortization.

Pronunciation Guide: The first rule in using this financial shibboleth is knowing how to say it correctly; it is pronounced strictly as two words with three syllables: /ē-bit dah/.  Pronouncing as one word followed by two letters is also acceptable: /ē-bit D-A/. It is not advisable to pronounce the term in any other way.  Some southerners, and some corporate CFO’s who came up the ranks with an accounting background (rather than the more astute Wall Street pedigree) have been heard to say /ēbiduh/ or /ehbiduh/. This betrays an amateurish knowledge of high finance and will engender snickers and silent chuckles from the white shoe financier. For example, George “Dubya” Bush might say to Dick Cheney: “Boy Dicky, I misunderestimated how much ēbiduh Haliburton would produce with all yer kickbacks!”

Usage Note: This is the mother of all Financial Expressions. The grand poobah of the Financial Lexicon. One cannot even pretend to be a serious high finance person without knowing and using this term liberally.

The acronym refers to a measure of earnings taken from the income statement of a business. Oddly though, the word will not typically be found on a company’s official financial statements.  There is good reason for this.  The accounting standard setters (i.e. “bean-counters”) have laid out a fairly simple method for portraying an income statement.  Starting with revenues and then deducting things such as cost of goods sold, selling, general, and administrative expenses, and interest payments, taxes and other expenses, leaves net income or earnings the business generated for a given period.  Granted there are some tricky things accounting has to deal with such as at what point is a sale recognized as revenue, and how to allocate costs vs. expenses and so forth. But on the whole, the accountants tried to make it relatively simple for those who evaluate financial statements to understand whether a business generates profits or losses.

But hot-shot finance types apparently weren’t happy keeping things relatively simple.  They had to invent an earnings measure that wasn’t readily understandable by the common man.  It would also help if this measure was so loosely defined, you could “adjust” it a hundred different ways until losses become profits. Herein lies the genius of the finance guy’s invention: it has to be derived by someone with enough know-how to calculate the number from the items given on the income statement (or by someone with a top legal degree, as we’ll see shortly).

There are a number of absurdities attending the overuse and flagrant abuse of this metric.  To wit, 1) Although intended as a measure of earnings, it is frequently used interchangeably with the concept of “cash flow”. However, there are no items in the calculation of EBITDA that come from the cash flow statement.  It can take some serious accounting gymnastics using numbers from both the income statement and cash flow statement to reconcile EBITDA to “Cash Flow” which itself can be defined numerous ways (whether “Operating Cash Flow” or “Operating Cash Flow less Capital Expenditures” or “Free Cash Flow” including or excluding working capital).  Although used (often ignorantly, even by smart finance people) as a short cut for cash flow, it hardly bears any resemblance to cash flow at all.

keep-calm-and-adjust-the-ebitda (1)2) EBITDA is often the subject of numerous “pro-forma” or other “adjustments”.  Some financial gurus promote EBITDA as an equalizer that makes earnings more comparable between companies because it excludes the depreciation of assets from the calculation. Others, such as Private Equity types at LBO “shops” like using EBITDA because it measures earnings without regard to how the firm is financed (ie. whether a company has a lot of debt service or none at all). Perhaps they think if interest expense is ignored it will go away.

But EBITDA is frequently the subject of so much adjustment and manipulation, it can’t (in all honesty) be a reliable like-for-like comparison from one company to another. Yet the industry continues to overuse the measure in the 1 billion comp tables produced by finance professionals annually. Miraculously, “Adjusted EBITDA” can turn negative earnings (losses) into something that looks like robustly positive results. Take for example this “EBITDA reconciliation” for Energy Future Holdings Corp. (formerly TXU before it was destroyed by private equity owners) where all kinds of expenses, fees, and accounting adjustments turn a $3.3 billion net loss into a $5.3 billion positive EBITDA.

3) Perhaps the biggest flapdoodle in the proliferation of this term is that what likely started out as an informal short-cut measure of earnings or proxy for cash flow to be used as insider’s smart-talk, has been formalized into highly engineered, concrete legal definitions, with serious matters of consequence tied to the resulting number.  Astoundingly, EBITDA (often called “Consolidated EBITDA”) has found its way into credit agreements and bond indentures of all stripes, with definitions strictly detailed and contrived by armies of legal brains racking up billable hours.  Sure enough, once you let a lawyer touch a financial term created by half-witted finance geeks, it turns into the most heinous, execrable convolution known to man.  To add insult to injury: like a snow flake, no two of these Consolidated EBITDA definitions are alike.  Take for example these actual credit agreement EBITDA definitions: this from Crosstex Energy LP or this one from Reynolds American, Inc. logging in at a preposterous 1,372 words.  There are enough ingredients in there for a management team to cook up any EBITDA they want.  And all sorts of things are tied to the EBITDA number; from management compensation to compliance with debt covenants to the cost of the company’s financing.

It is essentially impossible, even for professional investors, to calculate EBITDA from these definitions.  And that’s what the bankers and companies are counting on.  This is EBITDA sausage, and they don’t want investors to know how it’s made.  It would be pretty inconvenient if any old schmuck could calculate earnings to see if the company met its financial covenants.

Will the real EBITDA please step forward

Will the real EBITDA please step forward?

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5 thoughts on ““EBITDA”: Financial Expression of the Day

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