“I think that, every time you saw the word EBITDA [earnings], you should substitute the word ‘bullshit’ earnings.” —Charlie Munger
“Does management think the tooth fairy pays for capital expenditures?” —Warren Buffett
An exerpt from Financial Statement Analysis: A Practitioner’s Guide (3rd Edition) about the dangers of EBITDA.
Like many other financial ratios, EBITDA can provide valuable insight when used properly. It is potentially misleading, however, when applied in the wrong context. A tip-off to the possibility of abuse is apparent from the preceding illustration. By adding depreciation to the numerator, management can emphasize (legitimately, in this case) that although Rock Solid’s operating profits suffice to pay only 50% of its 2001 interest bill, the company is generating 125% as much cash as it needs for that purpose. Lenders derive a certain amount of comfort simply from focusing on a ratio that exceeds 1.0X, rather than one that falls below that threshold.
In their perennial quest for cheap capital, sponsors of leveraged buyouts have noted with interest the comfort that lenders derive from a coverage ratio greater than 1.0X, regardless of the means by which it is achieved. To exploit the effect as fully as possible, the sponsors endeavor to steer analysts’ focus away from traditional fixed charge coverage and toward EBITDA coverage of interest. Shifting investors’ attention was particularly beneficial during the 1980s, when some buyouts were so highly leveraged that projected EBIT would not cover pro forma interest expense even in a good year. The sponsors reassured nervous investors by ballyhooing EBITDA coverage ratios that exceeded the psychologically critical threshold of 1.0 times. Meanwhile, the sponsors’ investment bankers insinuated that traditionalists who fixated on sub-1.0X EBIT coverage ratios were hopelessly antiquated and unreasonably conservative in their analysis. In truth, a bit of caution is advisable in the matter of counting depreciation toward interest coverage. The argument for favoring the EBITDA-based over EBIT-based fixed charge coverage rests on a hidden assumption. Adding depreciation to the numerator is appropriate only for the period over which a company can put off a substantial portion of its capital spending without impairing its future competitiveness.
Over a full operating cycle, the capital expenditures reported in a company’s statement of cash flows are ordinarily at least as great as the depreciation charges shown on its income statement. The company must repair the physical wear and tear on its equipment. Additional outlays are required for the replacement of obsolete equipment. If anything, capital spending is likely to exceed depreciation over time, as the company expands its productive capacity to accommodate rising demand. Another reason that capital spending may run higher than depreciation is that newly acquired equipment may be costlier than the old equipment being written off, as a function of inflation.
In view of the ongoing need to replace and add to productive capacity, the cash flow represented by depreciation is not truly available for paying interest, at least not on any permanent basis. Rather, the “D” in EBITDA is a safety valve that the corporate treasurer can use if EBIT falls below “I” for a short time. Under such conditions, the company can temporarily reduce its capital spending, freeing up some of its depreciation cash flow for interest payments. Delaying equipment purchases and repairs that are essential, but not urgent, should inflict no lasting damage on the company’s operations, provided the profit slump lasts for only a few quarters. Most companies, however, would lose their competitive edge if they spent only the bare minimum on property, plant, and equipment, year after year. It was disingenuous for sponsors of the most highly leveraged buyouts of the 1980s to suggest that their companies could remain healthy while paying interest substantially greater than EBIT over extended periods.
Naturally, the sponsors were prepared with glib answers to this objection. Prior to the buyout, they claimed, management had been overspending on plant and equipment. The now-deposed chief executives allegedly had wasted billions on projects that were monuments to their egos, rather than economically sound corporate investments. In fact, the story went, investments in low-return projects were the cause of the stock becoming cheap enough to make the company vulnerable to takeover. Investors ought to be pleased, rather than alarmed, to see capital expenditures fall precipitously after the buyout. Naturally, this line of reasoning was less persuasive in cases where the sponsors teamed up with the incumbent CEO in a “management-led” buyout.
Investors in many of the 1980s transactions were advised to take comfort as well from the fact that a portion of the annual interest expense consisted of accretion on zero-coupon bonds, rather than conventional cash coupons (interest payments). By way of explanation, investors buy a zero-coupon issue in its initial distribution at a steep discount—say, 50%—to its face value. Instead of receiving periodic interest payments, the purchasers earn a return on their investment through a gradual rise in the bond’s price. At the bond’s maturity, the obligor must redeem the security at 100% of its face value.
By using zero-coupon financing along with conventional debt, LBO sponsors could generate financial projections that showed all interest being paid on schedule, while at the same time making capital expenditures large enough to keep the company competitive. Often, the projections optimistically assumed that the huge debt repayment obligations would be financed with the proceeds of asset sales. The sponsors declared that they would raise immense quantities of cash by unloading supposedly nonessential assets.
With the benefit of hindsight, the assumptions behind many of the LBOs’ financial projections were extremely aggressive. Still, the sponsors’ arguments were not entirely unfounded. At least some of the vast, diversified corporations that undertook leveraged buyouts during the 1980s had capital projects that deserved to be canceled. Some of the bloated conglomerates owned deadweight assets that were well worth shedding.
The subsequent wave of LBO-related bond defaults, however, vindicated analysts who had voiced skepticism about the new-styled corporate finance. Depreciation was not, after all, available as a long-run source of cash for interest payments. This was a lesson applicable not only to the extremely leveraged deals of the 1980s, but also to the more conservatively capitalized transactions of later years.