EBITDA Doesn't Spell Cash Flow: Part 4

So what can we do to make these common covenant measures more effective? For starters, we can replace EBITDA with FCF in order to take into account the inevitability of taxes, capital expenditures, working capital expansion, and dividends. Then we can think about how to deal with non-recurring expenses and extraordinary charges.

           As the ratios below demonstrate, broadening the definition of debt to include capitalized lease obligations and replacing EBITDA with EBITDAR and FCF paints a much more alarming picture of Beatid than the EBITDA ratio snapshot:

Beatid’s Leverage and Coverage (X)      2014             2015              2016

Sr Dbt/EBITDA(X)                                       49/45=           140/40=         109/68=

                                                                         1.09                3.50              1.60

Total Dbt/EBITDA (X)                                 87/45=           194/40=         233/68=

                                                                         1.93              4.85               3.42

EBITDA/(P+I)                                               45/17=           40/16=           68/30=

                                                                         2.65            2.50               2.27

EBITDAR/(P+I+R)                                       50/22=           52/28=           88/50=

                                                                         2.27              1.86              1.76

(Tot Dbt +CLO)/EBITDAR                      117/50= 254/52=         353/88=

                                                                       2.34                 4.88             4.01

(Tot Dbt + CLO)/FCF                                  117/-2=          254/-95=       353/-48=

                                                                         n.m.                n.m.            n.m.

FCF/(R+P+I)                                                -2/-22=           -95/-28=        -48/-50=

                                                                       n.m.             n.m.             n.m.

n.m.=not meaningful

           If FCF had been used instead of EBITDA or even EBITDAR, Beatid’s cash flow problems would have been uncovered at the outset. Another problem is the use of, variations on the debt/EBITDA ratio in pricing grids that penalize the borrower by boosting the borrowing rate as the ratios increase. Pricing grids perform a useful function of keeping the return commensurate with the rising credit risk, but using the same ratio for both pricing and covenant control raises the issue of whether a covenant default waiver can be purchased by paying a higher rate. A simple solution is to first, avoid using the same ratio as both a pricing ratio and a covenant control ratio, and second, make the debt component of the pricing measure as broad as possible. After all, the point of the ratio is to keep the return commensurate with the risk. Further, using only senior debt motivates a borrower to avoid more senior debt in favor of subordinated debt or leases.

           Subordinated Debt. In order to control the mix of senior and subordinated debt, lenders typically set limits with both a total debt ratio and a senior debt ratio. Subordinated debt is not as subordinated as it may seem; most subordinated debt today receives principal and interest along with the senior debt, and it is subordinated to senior debt only after an event of default occurs. Further, subordinated debtholders usually can declare default on their debt, too, and given that this riskier debt typically is more expensive, its debt service can be a painful competitor with the senior debt.

           Capex. Sometimes, lenders estimate the minimum level of capital expenditures needed to maintain the company’s current fixed asset investment because “maintenance Capex” protects the existing long-term earning assets of the borrower by forcing the borrower to budget enough Capex to support its existing plant and equipment. However, using an estimated maintenance Capex instead of the actual Capex tends to overstate the FCF available to repay lenders, especially for fast growth companies where repayment of the debt incurred to finance sales expansion depends upon increasing the fixed assets as well.  In the case of Beatid, using an annual maintenance Capex of $10MM instead of the actual $230MM for the 2014-2016 period would have overstated FCF by $200MM (($37 + $102 + $91) – ($10 + $10 + $10) = $200)).

           Non-recurring Expenses and Extraordinary Charges. Non-recurring expenses and extraordinary charges tend to be inaccurately named when they seem to occur year after year. Technically speaking, these items are not cash expenses in the year recognized, but they indicate that expenses were understated in prior years, and, therefore, the previous years’ profits and the EBITDA figures derived from them were overstated. One way to discourage this behavior and add some cushion to the EBITDA, EBITDAR, and FCF measures is to “adjust” these various cash flow indicators by deducting these non-recurring, extraordinary items.  The result may understate the cash flow estimate a little, but it is an error on the positive side for the lender.

           The Final Solution. An alternative to adjusting EBITDA to EBITDAR to FCF is just to rely on operating cash flow NCAO is the firm’s cash position after accounting for revenues collected, costs paid for producing goods and services, payments for operating expenses, and other recurring items. CADA represents the cash after DSC and dividends have been paid that is available for Capex.  Beatid’s three years of results below illustrate and compare the NCAO-CADA approach to FCF as well as provide two coverage ratios based on these measures. First, the FCF surplus/deficit results in a close approximation of the NCAO surplus/deficit:

Beatid’s, NCAO, NCI,

and CADA (SMM)                        2014              2015             2016

Cash collected from sales             566              616              666

-production costs                            -460              -526              -537

-operating costs                               - 82              -104              -123

-other income (expenses)                  5                  22                  25

Net cash after operations(NCAO)  29                   8                 31

-interest expense                            -  7                 -11              - 16

-dividends                                        -  3                 - 4                -  8

Net cash income (NCI)                    19                 - 7                   7

-principal repayment                       - 10                - 5                - 14

Csh after dbt amortiztn(CADA)         9                 -12              -  7   

-capital expenditures (CAPEX)     - 37              -102               - 91

NCAO Cash surplus/(deficit)        - 28              -114              -98

FCF cash surplus/(deficit)               -24              -123              -98

Cash Flow Ratios (X)

NCAO/(P+I)                                      29/(7+10)=    8/(11+5)=      31/(16+14)=

                                                           1.71x             .50x                1.03x

CADA/(P+I)                                      9/17=            -12/16=          -7/30=

                                                           .53x               n.m.               .n.m.

n.m.= not meaningful

 Second, Beatid’s NCAO has been insufficient is to cover interest expense, principal, dividends, and capital expenditures, and the result has been three years of NCAO cash deficits totaling $240 million. Using EBITDA instead of NCAO grossly overstates Beatid’s cash flow, but FCF comes much closer to the NCAO cash deficit figure. 

           Finally, the cash flow ratios illustrate the cash flow shortfall. The objective of the first ratio is to compare earnings adjusted for non-cash items (NCAO) with working capital changes as the basis for testing the ability to repay. It is unrealistic to expect the company to reduce its working capital investment and potentially restrict sales growth in order to repay borrowings partly incurred to finance the company’s growth strategy. If NCAO exceeds debt service (P + I), then CADA will be positive. The second ratio reflects the effect of dividends, which, as mentioned earlier, are generally necessary to maintain the value of a publicly traded stocks. Although borrowers are unlikely to like these ratios, they offer a much more insightful measure than EBITDA-based ratios.

Closing and Summary     

           I have  described and explained why EBITDA is not really cash flow, and I have also offered some alternatives on how to adjust EBITDA into a better approximation of cash flow.  EBITDA remains a popular tool for the financial services industry to structure deals. Despite FAS 95’s implementation of the cash flow statement in 1987, the financial community prefers the simplicity of EBITDA to the more complicated CFO. An income statement is enough to calculate EBITDA, but CFO requires two balance sheets bracketing an income statement in order to find the changes in assets, liabilities, and equities.  In their search for core cash flow earnings, analysts relying on EBITDA to measure debt carrying and repayment capacity overlook the cash requirements for working capital, capital expenditures, dividends, and taxes. EBITDA works satisfactorily for the firm that does not have any revenue growth requiring working capital expansion or fixed plant additions, does not pay dividends to their stockholders, and does not have any income on which to pay taxes. However, what lender wants to finance a stagnant, unprofitable firm? 

            EBITDA does not work well for fast-growing companies, but bankers can transform EBITDA into FCF, which does take into account working capital changes, CAPEX, dividends, and taxes. EBITDA may not spell cash flow, but FCF is sufficiently close to being a letter-perfect version of the real thing. As Joni Mitchell sang, 'Don't it always seem to go that you don't know what you got till it's gone,?" It's time to replace EBITDA with FCF.