I have been self-employed most of my adult life and even as far back as 14 years old. I was never a financial guru, but I was always good with money and math. I always understood basic business concepts like my cost of goods, gross profit, basic tax law, and how it affects my business. I also have purchased 18 companies in the last 20 years, and in the process, reviewed about 50 companies. That includes seeing their books and dealing with business brokers who are using all sorts of different analyses to make the books look good.
One term that has been floating around for years is a thing called EBITDA. That stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It is not uncommon for business owners to talk to each other about their EBITDA. When discussing buying or selling a company, EBITDA is a common term thrown around. I have always felt that it was not an accurate indicator of current cash flow and profits that are necessary to operate a business – especially a small business.
Well, it turns out that my instincts were right – at least according to Warren Buffet and Charlie Munger (Warren Buffet’s long-term business partner.) In a recent article, Munger said, “I don’t like when investment bankers talk about EBITDA, which I call bulls--- earnings,” he said.
“It’s ridiculous,” Munger said, noting EBITDA — does not accurately reflect how much money a company makes, unlike traditional earnings. “Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”
Warren Buffet said as far back as 2003; “We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE, and Microsoft — they’ll never use EBITDA in their annual report.
So what’s the big deal? Let me try to explain this in very simple terms. EBITDA takes out things that a business actually spends money on. Interest, taxes, depreciation, and amortization are real expenses. It can be argued that depreciation is a tax-adjustment that is only a portion of the actual expense. However, it still represents real money that was spent. In fact, it actually understates spending. The only reason it exists is that the government puts limits on what and when you can deduct certain expenses from your income. Interest is always real money, so I see zero rationale to exclude that in the EBITDA calculation.
Let me give you a specific example from my business. We recently bought some new equipment that costs $150,000. We paid cash for it. According to tax law, we have to depreciate that expense over five years. But they also have a law where we can accelerate the depreciation on a purchase into one year up to a certain level. This year, we can depreciate the entire $150,000. According to the EBITDA formula, when reporting our income, we would take out that $150,000, thus showing we made a profit of $150,000 more this year. However, we actually spent the money. I have $150,000 less in my bank account. My actual tax return shows we made $150,000 less also. (Note if someone is lending you the money to invest in equipment, this analysis gets muddy. For the sake of this argument, I am assuming all money to run and expand your business comes from business profits.)
If I were to use EBITDA to make future business decisions, I would be lying to myself, thinking I had $150,000 more to work with. If I were selling the company and used EBITDA as part of the valuation of the company, I would be lying to the buyer.
What matters to all business – but especially small business - is real cash flow - the real dollars that come in and out of your bank account. EBITDA is Fake News when it comes to your bank account.
If you really want to know where you stand, you need to have a handle on exactly how much operating profit or loss that includes all expenditures – whether they be capital investments or essential expenses.
Don’t be fooled by Fake News!