Is EBIDTA the Holy Grail of Understanding a Company?

I remember the first time I was in a classroom at the bank I worked for in Jefferson City, Missouri.  I was a seasoned banker, but quite a young pup when it came to the commercial and agriculture side.  One of my banking mentors taught a short class on how to figure the Debt Service Coverage Ratio (DSCR).  This is figured by taking EBIDTA (Earnings Before Interest Depreciation Taxes and Amortization) divided by the annual debt service requirements for the firm. 

I was amazed.  I was looking for the holy grail, the excalibur that I could use to dissect the financials of a farmer or a business and gain clarity of whether the company could manage the proposed debt requirements for the loan request.  I thought I had just conquered commercial lending.

EBIDTA or another similar term, Net Operating Income, is not only used in calculating the DSCR but is also used in figuring value by using Cap Rates.  So now I was even more excited that I could not only see if the company could service its debt, but I could get a value of the company or the collateral as well.  Now the conquering of commercial lending turned into a mastery of the subject.   High fives all around.

My mom always warned me about getting "too big for my britches”.  That is good advice, as life is a constant learning experience, and just when you think you are really solid, get ready for a fall.  This was the case with my supposed mastery of the subject.  I quickly learned there is no holy grail, only road signs to help you determine the health of a firm.

It all came clear with a manufacturing company who wanted to acquire a new machine.  I did all the due diligence and determined that the customer could historically service his existing and proposed debt based upon my EBIDTA and DSCR calculations.   I completed my write-up and sent it to my boss.  The wise sage requested to see a detailed depreciation schedule.  I wondered why, since you could get the whole depreciation figure from the income statement without looking at the schedule. 

The sage called me in the next day and said, "Young grasshopper, the company has three pieces of machinery that will need to be replaced next year according to their history and depreciation schedule.  Where will the capital come from for the machinery?"  The manufacturer had equipment or parts that went on larger pieces of equipment which would wear out every two years and need to be replaced.  Since the replacement would be completed and benefit the company beyond this fiscal year, they capitalized and depreciated the asset instead of expensing it as a repair item. 

So, I had failed to account for that planned expense.  Calculating it in took my slam dunk deal into questionable territory or maybe a denial.  I trudged back to the company's CFO to get more answers. 

An important factor in analyzing a company is to look at required and necessary capital expenses that will be required to maintain the current level of production.  For my firm, the $150K for machinery press and drill parts was necessary for keeping three key machines running to continue production of granite countertops; otherwise, the company could not machine cut the countertops and would have to cut all by hand.  This would either require more staff or less production, either of which would drop the NOI substantially.  We had to uncover how those items would be paid for.  In this case, the company had set aside most of the money and was planning to pay for the last 1/4 with cash from several large sales they were to get in the next two months. 

This was a case in which only looking at the EBIDTA or NOI to figure the DSCR was not enough.  It required a further look into the planned capital expenses to determine the adequacy of cash in the company.

It is possible that the EBIDTA number can be understated.  I have banked with some hotel operators, who will expense any repair or improvement item for the hotel:  light bulbs, replacing broken furniture, new carpet, or repaving the parking lot.  All of these have different treatment accounting-wise.  The light bulb is a consumable item that should be run through the repair expense.  Replacing broken furniture can either have an expense for the broken piece depreciated out and the new one capitalized, or one could just expense the new one in the repair line.  The carpet should be depreciated over the expected life of the carpet.  In the case of this hotel, it was around 5 years.  The parking lot had an expected life of 15 years. 

If all of these items were in the repair expense, it would be counting repair items that would not necessarily be occurring every year.  Perhaps you may want to do that if you have a property that is requiring large amounts of ongoing capital investment year after year.  But in most cases, the one-time expenses should be pulled out, and a capital expense allowance can be used.  This is an estimate that on an average given year, some percent of gross income (usually 3-5%) will be spent on capital improvements for the property.  Using this method will help average out the EBIDTA in years when improvements are made and expensed, and in those years when no additions are done.