Increasing your EBITDA – you’re doing it right - A sarcastically scientific approach
In my previous articles I highlighted certain actions occasionally undertaken by management in order to show EBITDA earnings which would be better received by analysts and investors. Those actions were mostly wrong in their nature if not fraudulent in general so the article was more of a guideline on how to avoid such pitfalls for those who might be misled by such reporting.
In this article on the other had I would like to discuss two? genuine methods of increasing EBITDA which might be considered by bold and visionary managers. The article is based on certain non-scientific research and many issues raised in it might be viewed as far fetched or even risky to propose in certain circles. Nevertheless I dare presenting my opinions below.
1.?????? Grow your revenues
Under the orthodox school of thought a business that generates more revenues (provided that the unit economics is sound) gradually generates disproportionately more earnings since at least some of its costs are fixed and thus – margins grow.
Some writers insist on a relationship that exists between having an ever bigger group of satisfied, paying clients and reported profits (including EBITDA). This was shown in more recent studies (A.I. Silverberg et. al., “Apple and Samsung. Does more clients and good margins actually mean more profits?” Contemporary Problems of Basic Accounting, 2020) as well as some older ones (T. Chekhov, F. Stoianov, “Analysis of determinants of Microsoft’s profitability”, Journal of Outdated Investment Management, 1998).
From their works it transpires that good product, proper sales processes, existence of a market with willing buyers and a pricing strategy that both attracts those willing buyers and at the same time ensures profitability, play a role in a consistent reporting of good EBITDA earnings.
This is however a particularly controversial proposition and the approach is not easily received, facing a lot of criticism as “scientific ie. purely theoretical”. Interviewees in a study of a focus group designed by Whitepoint Strategy Consultants (mostly CEOs and venture capitalists) pointed out to a fact that: “[…] revenue cannot be the answer as it is both difficult to achieve and hard to measure. And historical evidence provides more than enough of examples of companies that brought some significant wealth to its shareholders despite making no revenue whatsoever”.
Indeed it is difficult to argue with this statement given the examples of Theranos or IRL.
Nevertheless as a conservatist I remain deeply convinced that more sales at positive margins must generate more profits. A number of simulations I performed in excel contributed to this conviction and regardless of how simplified those simulations might have been if compared against the complexity of the market – the consistency with which the addition of marginal revenues exceeding costs of goods sold always produced more earnings, at least suggests some causation.
To support this view I. L. Hue and J. Malone of University of Southern Madagascar found little or no correlation between:
When talking about revenues it is unavoidable to address one more concept which more than often is used to cover structurally non-existent profitability. The concept is called GMV (or Gross Merchandise Value) and refers to the underlying value of goods processed through an e-commerce business.
Usually such businesses live off commissions from processing of the transactions (delivery, fulfillment or other services). A brilliant and insightful meta-analysis of such businesses by T. Hagenmeyer (“What to report when there is nothing to be reported?”, Buchhaltung Verlag, 2021) shows that when those commissions are unlikely to cover the costs of the business' operations even after a million years of steady growth, the business starts to report GMV – because (a) it is a larger number so looks far better and (b) no-one can really calculate future decimal percentages on such a large number so good prospects are easier to be presented.
It is worth noting that profitable businesses rarely revert to discussing GMV. In theory if Visa or Mastercard would disclose their GMV – it would be a really impressive number. But it seems – they do not really need to.
A whole bunch of authors attempted to prove a correlation between GMV and reported EBITDA. However – to the best of my knowledge – no-one succeeded.
2.?????? Control your expenses
A professional start-up entrepreneur once told me: “earning money is what many people can do, but in a start-up business you must learn how to spend money”. For many it seems to actually be their business motto of the start-up era.
Long gone are the times of having their initial setting in a garage (Apple, Microsoft, Google) or a dorm room (Dell). Nowadays the starting point must be an A class office building where the majority of the space is a mixture of a kitchen and a living room with world class cooks preparing meals and cocktails. We asked prof. Linda Tinkerton of The Department of Social Sciences (University of Aalborg) for her opinion since investigating the changing entrepreneurial habits is her field of study.
She explained that “there is more than one reason for the change. There is the element of the changing status of the first Parent investor. With the now wealthier parents funding their kids dream business – it is easier to place it in an office building. Back in the old days – all parents had to offer was their garage, which in those times was considered a sacrifice on their part (especially in winter).
Secondly – the new generations are more and more aware of the difficulties of working from the garage which given their emotional levels may lead to a long term trauma. Garages rarely offer meals, even coffee machines there are usually only of basic nature and do not allow for making a soymilk decaf lattes. And bad light cannot be overlooked here – potentially leading to the impairment of eye-sight.
Finally it seems that an important factor for the modern managers is also their awareness of how offensive their working from the garage might be for social groups sentenced by the society to working in garages permanently – car mechanics, just to name an example. New entrepreneurs believe that their working in top class, air conditioned, WeWork-looking offices and developing the new internet services based on a commission model will one day lead to freeing those locked in car garages to move up on a social ladder for the benefit of all.”
Regardless of those valid points it seems rational that the more expenses a business generates (especially upfront) – the more pressure there will be on the ultimate profitability and earnings levels. Some tend to question the approach. Ivan Mockovic is a post-graduate student working for a tech company in Milton Keynes, UK. He tells us: “I have been sitting on this couch for the last 3 hours sipping my favourite Indonesian coffee. I feel safe, I feel rewarded, I feel comfortable. Thanks to this – only today I already had 2 great business ideas. One I forgot, because I did not have my tablet with BrainStormNote app on it, but the other one I still remember and we will start implementing it from tomorrow on (after the morning coffee)”.
It is hard to argue contrary to this point. The example of Jeff Bezos who had his staff packing books on the floor, as the tables would only be bought when the business started making money is unbelievably distant and perhaps irrelevant.
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Conclusions
The mathematics behind the calculation of EBITDA seems trivial and inevitably leads to the claims, that were made in this article. More genuine revenues with unit economics ensured – will lead to higher earnings. Less expenses (especially fixed costs) – makes more room for profit. This might be called a classical theory.
Regardless of this – as shown in the article – there is a strong resistance to this view. The modern theory seems to make do without revenues and with high costs levels. By doing this they have no EBITDA to report (and it is unlikely to change in the future) and thus tend to progress towards an adjusted EBITDA, where they add revenues as they should be (given their efforts and merits) and deduct expenses which are excessive (and therefore are obviously attributable to developing some intangible assets and thus should be capitalised).
Whether the subject of the actual financial analysis is EBITDA or Adjusted-EBITDA will be the choice of an analyst or a venture capitalist. The only risk involved in the modern theory is that if you buy on Adjusted-EBITDA you will also have to sell on Adjusted-EBITDA, which will require finding a buyer as indifferent towards the laws of economics as yourself.
PS. All the references were made up and therefore are totally fake. Like with Chat GPT...