EBIDTA, a measure of operating
performance, is wrongly used as a measure of business
Three people – manager, stock analyst and lenders – look at EBIDTA differently.
When managers use market value or a lender’s
perspective to assess business performance, conclusions are misleading.
The difference is vividly understood in
a retail business.
An investment in a retail store occurs
at a point in time. It requires maintenance expenditure for 5 years, when the
store needs refreshing with a new round of capex. A retail store spends nothing
on capex for 5 years.
Retail operations are like trading income. EBIDTA overstates performance. No capex item appears in cashflow for 5 years.
A banker seeing retail numbers considers
the business credit worthy. Interest is a pre-tax cost. And they want to lend as long as interest is
And if the
retailer uses money to grow rapidly, the scale begins to mask a fact that new
stores may not be generating enough cash for refurbishment or to repay the
loan. Bankers/stock analysts see a highly leveraged company has more available
cash flow than the same business utilizing less leverage.
And if loan is close to default, loans
are evergreened. In the days of Amazonian disruption evergreening of loans further
debilitates a company’s ability to repay unless digital channels have begun to
compensate store foot traffic decline. Evergreening is a death knell of a
It is better
to use Net available
cash (NAC) as a basis of operational performance.
NAC = Profit after
tax of a business;
of cash for capital expenditures necessary after five-year,
Why do I
is a noncash expense, it contributes to cash and will be required to replace stores.
The timing of
generation of depreciation cash is different from its use. (The need to ‘provision
money in a bank (accumulating depreciation in the intervening five years) creates
the false positive and could result in misallocation of capital.
If capital expenditure
is more than cash available over a period of time, a company is undergoing
gradual liquidation, it is producing less cash needed to replenish assets.
stock analysts also differ in another dimension. Evaluation and valuation are
not synonymous. Valuation is an
estimation of worth, it assesses the operations of the business to see how
effectively and consistently it generates cash flow. Evaluation is an
assessment of the business organization and its relative and competitive operating
EBIDTA from one reporting period to the next is an incomplete representation of a company’s true financial health and performance.