EBITDA-AL Nooooooooo!

The publication of IFRS 16 coincided with the launch of my research franchise at UBS back in 2017. Which was great for us as it gave us plenty to write about!

I think the accounting changes were a good idea, getting the off-balance sheet lease commitment on-balance sheet. I was supportive of that. However, the unintended consequences of dealing with these changes in terms of metric comparability, the annoying differences between IFRS and US GAAP, and building DCF FCFF valuations (that's a rant for another day) were, in my opinion, very tricky for analysts to handle.

Again, given my experience (and I spent 7 years seemingly answering the same type of question about leasing implications on valuation), I don't think many analysts "get it," and I do think there are numerous valuations out there that are just plain and simply incorrect because how the analyst deals with leasing.

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This has led to the evolution of several shortcut solutions. Shortcuts are often dangerous, but they oversimplify and are sometimes a substitute for hard work and getting your hands dirty.

The evolution of EBITDA-AL

EBITDA-AL (Earnings Before Interest, Taxes, Depreciation, Amortization, and Adjusted Loss) is a non-GAAP financial metric that has emerged in response to implementing IFRS 16, the new leased accounting standard.

Before IFRS 16, companies had two main options for acquiring fixed assets: ownership or leasing. Finance (or capital) leases, where, to paraphrase the accounting rules, the leased asset feels like yours, were treated similarly to ownership on the balance sheet. However, operating leases were expensed as an operating cost, with no asset or liability recognized.

This created issues with the EBITDA metric. For companies that relied heavily on operating leases, their EBITDA appeared lower than peers who owned more fixed assets outright. To address this comparability problem, some used EBITDAR, which adds rent expenses for operating leases back to EBITDA. However, EBITDAR excluded all fixed asset costs from leases or ownership.

I never liked EBITDAR - you were ignoring a lot.

IFRS 16 changed this by requiring (almost) all leases to be capitalized on the balance sheet, similar to finance leases previously. Lease assets are depreciated, with interest on lease liabilities - expenses excluded from EBITDA. This boosted reported EBITDA for lease-heavy companies.

EBITDA-AL aims to recreate pre-IFRS 16 EBITDA by deducting estimates of the depreciation and interest related to those capitalized operating leases. In theory, EBITDA-AL is more comparable to a company's historical EBITDA.

However, EBITDA-AL has drawbacks. Like EBITDA, it ignores fixed asset costs by excluding depreciation and certain interest. It is a non-GAAP measure lacking standardization. And it still doesn't resolve the fundamental comparability issue for companies with different appetites for leasing versus outright ownership.

While EBITDA-AL may provide a transitional bridge from pre- to post-IFRS 16 analysis, critics argue it is an unnecessary step backward. IFRS 16's lease capitalization provides more transparent and relevant financial reporting. Rather than adjusting imperfect metrics like EBITDA, a multi-faceted analysis considering all expenses and capital costs is recommended.

In Conclusion

In conclusion, while EBITDA-AL serves a specific purpose for some in comparing pre- and post-IFRS 16 periods, it has significant limitations. A comprehensive, accrual-based analysis is favored over reflexively recreating flawed legacy metrics like EBITDA.

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