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Business Services Industry

At your own risk

Entrepreneur, Sept, 2003

AT YOUR OWN RISK: In recent years, the investing public fell hard for companies with strong earnings before interest, taxes, depreciation and amortization (aka EBITDA), viewing it as a tool to measure a company's fiscal health. But looking to EBITDA as a substitute for cash-flow calculations is a dangerous investment strategy, say experts.

"As an investment tool, it's fundamentally flawed," asserts John Percival, an adjunct finance professor at the Wharton School. "EBITDA was designed to help lenders figure out whether a company would be able to generate enough revenue in the short term to pay interest on a loan." It's not intended to show how well a business is doing, says Percival.

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"A true cash-flow number is a lot of work," Percival points out. "You have to adjust for changes that have taken place in working capital and take into account that you have to invest in capital expenditures to grow your business." By contrast, EBITDA is easy to compute: Add depreciation, amortization and operating income. One presumption makes the figure particularly dangerous for investors: "It presumes all revenues are collected, that you don't tie up anything in accounts receivable or inventory, and that you never have any issues with payables," says Percival. "So it tends to make companies look good." And that's just the kind of sugarcoating today's binge-recovering investors don't need.--J.P.

Business Services Industry

At your own risk

Entrepreneur, Sept, 2003

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