EBITDA Is Not Remotely What You Think It Is
Conventional wisdom often diverges from the truth it tries to represent. For example, the north star, commonly held to be the brightest in the sky, is barely in the top 50. This mistake, fortunately, has little practical application for business people. Other pieces of common knowledge, such as EBITDA is the same as cash flow, can cost you an unaffordable amount when buying or selling a business.
EBITDA is Earnings Before Interest Taxes Depreciation and Amortization. You’ve heard of it – far too frequently. This, non-GAAP metric, is basically equivalent to pre-tax operational net income. EBITDA is a measure to compare the operations of two or more companies adjusting for: capital structure (debt pays interest, equity does not), buy/lease decisions (depreciation is recorded for owned assets, but not leased assets), and taxing jurisdiction (taxes in California are higher than, for example, Nevada). That’s it.
Take a look at a condensed Income Statement. Here we can clearly see the divergence of EBITDA and net income (more about cash flow to follow):
We’ll return to this income statement momentarily. In the meantime, suppose you are applying for a mortgage loan for a summer cottage. The loan officer will want to know your annual, after-tax income after debt service. This is the money available to you to service your loan payments – your free cash flow. The loan officer does not allow you to add back interest payments on your primary residence – that money is already spent and can’t be spent again.
If you do not pay your income taxes, you may face an audit. It will not help you to tell the auditor that you are on the “EBITDA method” and so taxes are not applicable. Taxes are due and are paid with cash. Interest is due and is paid with cash. Depreciation is strictly non-cash, however it represents degradation of an asset that presumably will need replacement – by paying cash.
These monies are already accounted for – due and payable. They are unavailable for any other purpose and therefore are nothing like free cash flow. Free cash flow, has its own name because it’s its own thing. Free cash flow is money that is not obligated and, therefore, can be used for discretionary purposes such as paying dividends, making distributions or buying summer cottages.
If you are interested in cash flow, the only useful part of EBITDA is the E – earnings. Even earnings are not free cash flow because the later, but not the former, accounts for principal payments on debt and fluctuations in balance sheet line items such as accounts payable and accounts receivable.
Where EBITDA is mostly insidiously used is in mergers and acquisitions, specifically for small businesses. The price-to-earnings ratio (P/E), or multiple, is intended to represent the amount of time over which a buyer’s investment is returned by earnings from the acquired business. For example, imagine the company, with the income statement above, sells for $50,000 (a P/E of 2.0x).
The idea here is that, all things equal, the buyer will earn $25,000 per year and recoup his investment in two years, at least in earnings, if not cash flow. While net income is an imprecise measure of cash flow, it far exceeds the validity of EBITDA, which intentionally deviates by adding back costs and expenses as discussed above.
Let’s assume earnings are the same every year. If the seller, and the broker, told you the price was $50,000 and that is two times earnings, you would expect to make your money back in two years, but, you instead might go out of business before you recouped your investment after year ten.
I don’t know how EBITDA became thought of as cash flow, but it is not! It is intentionally, by design, by definition, nothing like cash flow. In fact, EBITDA has no practical value whatever to a business operator. My advice is to remember that EBITDA does not equal cash flow, or simply to forget the term EBITDA altogether – it won’t cost you a thing.