When a highly leveraged company appears stronger than a conservative company
EBIDTA, a measure of operating performance, is wrongly used as a measure of business health.
Three people – manager, stock analyst and lenders - look at EBITDA 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. EBITDA 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 payable.
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 business.
It is better to use Net available cash (NAC) as a basis of operational performance.
NAC = Profit after tax of a business;
minus ‘provision’ of cash for capital expenditures necessary after five-year,
minus loan repayment.
Why do I suggest this?
Depreciation 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 of cash’)
Accumulating 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.
Managers and 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 effectiveness.
EBITDA from one reporting period to the next is an incomplete representation of a company’s true financial health and performance.