The Advantages of EBITDA

Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:

• Operational Comparability:  As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice.
• Cash Flow Proxy:Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
• Debt Coverage Ratios:In many lender contracts, certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.

The Disadvantages of EBITDA

While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.

• Overstates Income:  To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality by measuring income before a bunch of expenses. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTERaccounting for all expenses, including interest expense, depreciation expense, and income tax expense.
• Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
• Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).

Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.