EBITDA, EBITDA, EBITDA, That’s all Folks! Or is it?

The concept of EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) gained popularity as a measure of a company’s financial well-being in the late 1980s, coinciding with the emergence of Michael Milken and the Junk Bond Market. Since then, it has been widely used to evaluate companies for potential purchase, merger, or sale. EBITDA is often considered an approximation of cash flow, essential for various present value analyses used on Wall Street.

I once conducted research for a paper on why the Statement of Cash Flows was a better predictor of bankruptcy (i.e., future financial performance) than the Income Statement. To my surprise, the scholarly research conducted by several PHDs showed that GAAP Net Income was superior. These analyses looked at companies over three years, not the short term. However, due to the many factors affecting the true nature of a business and the potential for manipulation of all financial reports to some degree, GAAP Net Income emerged as the superior measure.? In essence, Net Income is king when trying to capture all the ongoing and future activities of a functioning business into a single report. This may be why Net Income is also a better predictor of future stock prices.?

My work with many companies has revealed some surprising findings when reviewing their financial reporting. One company, for instance, had come up with its own interpretation of EBITDA. It conveniently ignored additional expenses from the calculation, resulting in a highly overstated number and considerably higher bonuses for certain executives. This is a stark reminder of the potential for manipulation in financial reports and the need for vigilance when evaluating a company's financial health.

As the saying goes, Buyer Beware! EBITDA should not be the only accounting term you know. It is not the best or only measure to consider. EBITDA is just one snapshot that provides some information, and it is not the end all when buying a business or evaluating future economic performance. By considering a comprehensive range of measures, you can better understand a company's financial health and avoid costly mistakes.