I was skeptical from the very beginning–I saw way too many peers from the financial and operational ranks who were jumping on board too quickly with this so-called proxy for cash flow.
I’m not the EBITDA police. However, we are supposed to be some of the most exceptional financial teachers and mentors in the country. Accordingly, I want to explore four reasons why I believe many financial statement readers cling firmly to their beloved EBITDA financial measure.
The Halo Effect
Every consultant on the planet should read The Halo Effect. When you finish it, reread it. I guarantee that you’ ll never be more grounded with the mental tapestry of your very own business and financial convictions. You might even toss out a few closely-held business paradigms after your second reading of Rosenzweig’s book.
In short, this particular bias occurs when we place a halo over those we admire or respect. I’m convinced that the reason many financial statement readers like this measure is because they picked it up along the way from an expert they really like or revere. I fully understand–it’s easy to do.
What would happen if Michael Gerber, Tom Peters, Verne Harnish or Jim Collins started claiming that a company’s sales would skyrocket after painting the corporate offices lime green? How many business leaders would head to the nearest Sherwin-Williams to begin a new growth initiative?
Let’s try this–would you be using EBITDA if you had never heard of the term? Have you ever wondered why you or your clients embrace EBITDA for a proxy for cash flow? I’m interested in hearing your response.
I’m convinced that the main reason so many financial analysts and business leaders use and rely on EBITDA as a financial metric for cash flow is due to the cognitive bias, The Halo Effect.
I cannot bring myself to call my peers lazy. Slothful? That seems tamer.
What I mean is that EBITDA is easy to calculate, maybe too easy. If the goal is to truly understand cash flow or free cash flow, why not just calculate it instead? Sure, it takes a few minutes. So what? It’s more accurate. Plus, you gather other insights when you go through the process.
Cash flow statements can be created and automated in a matter of minutes, yet EBITDA typically wins out due to its simplicity which means less work for both the reader and the preparer of financial statements. Does this mean that the goal is to expend as few brain calories as possible?
I first heard the term sophistication bias from Patrick Lencioni in the book The Ideal Team Player. I immediately knew what he meant, but I’m not sure that bias is one that we’d find Daniel Kahneman using (if so, please let me know).
Similar to my comments about slothfulness above, financial statement readers tend to flee from cash flow or free cash flow calculations because of lack of understanding. I still serve CEOs who are financially savvy but don’t understand cash flow statements. Perhaps that’s our problem because we tend to burp out the indirect method of reporting operating, investing, and financial cash flows. While you and I think this presentation is easy to read, the concept is a bit abstract to financial statement readers outside our field of expertise.
Replacing EBITDA with free cash flow means having a solid understanding of the balance sheet and its impact on a company’s liquidity or financial well being.
Dave Potter, the KPMG partner who hired me at his firm’s St. Louis office once told me a good CEO could manage the P&L. A great CEO manages the balance sheet. It took me several years to understand the meaning of his message. A CEO who can adequately manage the balance sheet is managing the P&L too. So true. It also means they have a firm grasp on operating and free cash flow.
Depreciation, It’s a Real Expense
Years ago, I was in a management meeting, and someone asked about depreciation. Before I could comment, the controller jumped in and said that depreciation was not a real expense. I didn’t have the chance to comment at that meeting. Don’t worry, the controller and I spoke later.
Early in my career, I was studying the costing process of a wire rope company. The inside of the plant looked like a scene from the World War II era. All of the equipment was old and fully depreciated. Because the machinery was fully depreciated, there were no inclusions for an equipment charge in the pricing estimates for customers (at a minimum, they should have included a capital charge equal to the cost of leasing similar or slightly newer equipment).
Accordingly, that’s my biggest gripe about EBITDA. It’s like net income without some really, really important costs. Randall Bolten nails it when he similarly describes EBITDA in his book Painting With Numbers:
Put another way, the English-language translation of EBITDA is “our company’s earnings, if you don’t count a bunch of expenses we’d really rather not talk about.”
Search “Charlie Munger EBITDA” and you’ll find similar views.
Isn’t EBITDA the Language of Small Business M&A?
Yes, yes, yes. I run my practice under the name G3CFO. Many of my clients are subjected to The EBITDA Conversation™ where I teach how businesses are priced by business owners, generally sophisticated strategic and financial buyers. The EBITDA Conversation™ is my all-time favorite financial literacy training framework that I’ve created.
In short, most of my clients used to think their businesses were worth some multiple of EBITDA as such:
Adjusted EBITA * EBITDA Multiple (as told to them by gurus) = A Reasonable Proxy for the Value of their Business
Before moving on, do you see anything wrong with the equation above?
The equation above is a simple mental model. But it’s a backward way of arriving at a value for a business. That’s because you are multiplying an independent variable by a metric. The metric, EBITDA Multiple is Business Value divided by Adjusted EBITDA.
You see, the EBITDA multiple is a result. It’s derived by taking the pricing one is willing to pay for a business divided by adjusted EBITDA.
When I’m asked to value a business, I start with Free Cash Flow and then I back into what I’m willing to pay for the company based on risk I’m eager for them to take on. The number I start with is a floor, my beginning number. I have a ceiling which is up to the seller to figure out.
Then, and only then do I calculate the EBITDA multiple, but just out of curiosity. Plus, I know the seller is going to calculate it too.
Using the EBITDA Multiple mindset ignores the qualitative reasons why a cash-centric buyer will either be willing to pay more or less for a business:
- Sales growth opportunities including market share
- Increased earnings potential
- Business synergies
- A shortcut to better or newer technology
- The management team
Sure, EBITDA is a part of the small business M&A lexicon. Just be careful. Your clients need to know the full story.
A Little History of EBITDA
Perhaps I should have started with an EBITDA history lesson first.
You can do this on your own–enter EBITDA in Google’s Ngram Viewer which looks for frequencies of search strings in content dating back to 1500 (as long as Google has electronically indexed the content).
If you believe in the accuracy of the viewer, then EBITDA started hitting the airwaves around 1974.
The illustration above is consistent with what we learn from The Outsiders by William Thorndike. Thorndike explains that the CEO of a cable television giant started using EBITDA with lenders in the mid-80s to facilitate their torrid growth objectives. EBITDA then quickly caught on in other industries.
If you like your research very well done as opposed to rare or over easy, here are a few more sources on the origin of EBITDA:
- Wade Slome paints a slightly different picture of where EBITDA originated. You can find his brief article on Seeking Alpha entitled The Truth About EBITDA.
- What does EBITDA have to do with Zero-Coupon Bonds? This is an excellent 2007 post entitled The origins of EBITDA and Its Implications.
- The Accounting Trick That’s Killing WorldCom is a 2002 article and gives a brief history of EBITDA.
We Need a Solution
I’m not going to leave you hanging. Want to see what I do? At the bottom of my reporting, I normally include a line item for free cash flow which I define as operating cash flow after maintenance CapEx.
Periodically, I’ll have a CEO or shareholder ask me to include EBITDA. Sure, I’ll do it. But it always goes under free cash flow and after a quick conversation about the limitations of EBITDA.
Some Final Words for Those Embracing EBITDA
As I mentioned earlier, I’m not the EBITDA police. I only want financial statement readers to think holistically.
Sometimes, EBITDA is a proxy for free cash flow. That’s especially true in food service, professional services firms when client terms are less than 10 days, and in the software industry that uses a subscription model. Be careful in other industries. EBITDA can be miles apart from free cash flow.
Think about the following truisms with respect to EBITDA:
- EBITDA does not pay for income taxes, shareholder distributions, or debt reduction, only free cash flow does.
- If you take something away from earnings, you need to add something back. For instance, if you take away depreciation, you need to replace it with maintenance CapEx. If you remove interest, you better replace it with debt service.
- EBITDA also does not pay for company innovation, one of the primary and neverending responsibilities of being in business.
- Placing emphasis on EBITDA margins may lead to forcing out lower margin work that still leads to positive cash flow for the business.
Some paradigms are hard to shake. Is EBITDA one of those?