Are You Using EBITDA to Evaluate the Financial Health of A Company?2 min read

Think again. EBITDA is not a one-size-fits-all metric and can be easily manipulated, leading to a distorted view of a company’s financial performance. In this post, we’ll break down the limitations of EBITDA and why you should be cautious when using it as a measure of a company’s financial health. 💰🚫

👉 EBITDA is not a standardized GAAP metric, allowing for manipulation.

• There’s no standardized formula for calculation, leading companies to calculate it in a way that benefits them the most. 🤔
• Stock-based compensation, for example, may be included by some analysts and excluded by others. 💸

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👉 EBITDA implies that all net income converts to cash equally, which is not accurate.

• This metric ignores the required investment into working capital assets to support future growth. 💰
• This measure does not consider the required capital reinvestment. 💸
• While Depreciation and Amortization are non-cash items, CAPEX investments aren’t captured in the calculation. 💸

👉 It does not account for cash absorbed into working capital assets.

• Changes in receivables, payables, and inventory balances can lead to a distorted view of operating cash flow. 📉

👉 EBITDA implies that loan repayment is prioritized, which may not be the case.

• Companies may use cash for growth, acquisitions, or capacity expansions instead, leaving no residual capital for loan repayment. 🚀

👉 EBITDA doesn’t reflect the quality of earnings, leading to potential inflation.

• Earnings and EBITDA may be inflated with deferred expenses, aggressive accounting policies, or underfunded pension liabilities. 📈

👉 EBITDA is a poor measure of profitability due to differing accounting standards.

• GAAP revenue recognition criteria vary worldwide, which can overstate earnings. 📊
• Interest and taxes are real cash outflows that reduce earnings in practice. 💸

👉 EBITDA is inadequate for comparing acquisition multiples, as it doesn’t capture industry-specific requirements.

• It doesn’t account for industry-specific capital investment needs or company-specific underlying strength in operating earnings. 📉

👉 It can be misleading as a measure of cash flow due to its ignorance of real cash outflows.

• It ignores several real cash outflows and understates the future expected increase of those cash outflows. 💸
• Taxes and interest expenses are real expenses. 💸

👉 This metric can be easily manipulated.

• Management can manipulate earnings and inflate EBITDA through a variety of methods, including aggressive percentage of completion revenue recognition, deferring expenses, understating pension liabilities, and understating provisions. 🔧

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I think this covers the key points about the limitations of EBITDA. However, it’s worth noting that it can still be a useful metric in certain contexts, such as evaluating the operating performance of a company or comparing companies within the same industry. It’s just important to be aware of its limitations and not rely on it as the sole measure of a company’s financial health.