EBIDTA

When EBIDTA is Leaky

In my days as a young pup commercial lender, I first learned of EBIDTA.  To those of you in rural Missouri (where I came from) this stands for Earnings Before Interest expense, Depreciation, Taxes, and Amortization.  It may also be known as Traditional Cash Flow (TCF).  Basically, the thought here is, how much money does the company generate after paying all its operating expenses?  That is the amount you have left over to satisfy debt payments, make capital improvements, and reward the owners. 

To the lender, understanding this concept is incredible.  Now you have a tangible method to see if a business generates sufficient funds historically, or in projections, to make the debt payments required on the loan you are underwriting.  When I first discovered this, I thought I found the golden key that would unlock the mysteries of commercial underwriting.

The problem is that it only unlocked some of those doors and often, as in credit analysis, the answer may not indicate something good or bad, but point to further digging that needs to be completed.  One of the first examples of how wrong relying on EBIDTA came with the WT Grant bankruptcy in 1974.  Grant was a large retail chain with a long history of impressive earnings growth.  They had a strong TCF or EBIDTA.  To creditors it looks like they could easily handle the debt payments that they were required to make.

The bankruptcy caught a lot of creditors by surprise and this generated a large leveraged buyout.  What happened?   Almost all the TCF was eaten by increases in accounts receivable.  This left a fraction of the cash that was needed for debt service, instead of a multiple thereof.  Unfortunately, A/R does not pay the loans; cash does.

In this case, EBIDTA measurement failed to identify the leaks that drained cash from a business that looks outwardly profitable.  This set off alarm bells in the banking community and identified the need for a deeper dive in the analysis of the company.  Accountants went to work and began to create what became the statement of cash flows to help capture what is happening with the company cash from both a direct and indirect method.  Bankers created the Uniform Credit Analysis (UCA) method to analyze sources and uses of cash.  This has become a standard of spreading software that is used every day by lenders. 

TCF works generally well when you have a loan on commercial real estate, where the amount left over after EBIDTA is usually free of leakage and can be used for payments, CAPEX, and owner distributions.  But absent of that type of credit, your solid boat of EBIDTA, may end up being as porous as your kitchen strainer.  Consider these leakages:

Accounts Receivable may increase to levels where they use up cash and leave none available for loan payments.  A/R is not cash, but the sales do go into the top line of gross income and, if sold with a positive margin, will increase the EBIDTA.

Inventory is another use of cash.  I once looked at a retail business that continued to borrow repeatedly as they poured all profits back to getting more stuff they could sell.  Their inventory levels were so high that at then current levels of sales, it would take 2 ½ years just to sell through the stuff.

Accounts payable that are paid quickly are a use of cash.  Many times, generous terms with suppliers may help the company avoid the need of an operating line.  Having A/P turns that are much shorter than others in the industry may keep you on great terms with the suppliers, but also increases the need for borrowing.  I once studied an ice cream shop that had no debt, real estate of over $3MM in value, and took care of all their financing with 45 day terms with all their suppliers.

Capital expenditures, or CAPEX, can be a huge drain on EBIDTA.  If you have a business that requires the purchases of new equipment or long-term capital improvements to real estate for the business to continue to generate positive cash flow.  An example here would be a manufacturer who must replace machinery that normally wears out with use.  Another example is a hotel that has to replace case goods and floor coverings in a room.  In either case, large sums of money need to be spent to continue generating the top line revenue.

Owner dividends or distributions are also another leak of TCF.  Now people go into a business or purchase a piece of real estate, to receive some personal reward after satisfying all debt and operational expenses.  A challenge here is if the business owner or farmer drains off excessive amount of profit in good years, they may not have resources in the poor years to take care of your debt. 

So, is the EBIDTA or TCF that you are looking at subject to leakages?  This is an important analysis as you consider your possibility for repayment of your loan.