Pin Me

Looking at the Limitations of EBITDA

written by: •edited by: Michele McDonough•updated: 10/24/2010

If you employ EBITDA, earnings before interest, taxes, depreciation or amortization to find investors, that’s probably a fair practice. As far as really analyzing your business through and through, however, there are problems with EBITDA, especially for the small business owner.

  • slide 1 of 4

    Does EBITDA Serve a Purpose?

    EBITDA Could Be a House of Cards Your business needs investors or you need to get that loan at the bank so preparing a financial report that shows earnings before interest, taxes, depreciation or amortization (EBITDA) may be a great idea. After all, you want investors and lenders to look at your sales revenues and compare them against your projections right?

    EBITDA financial formats are often requested and utilized by lenders or investors but there are some problems with EBITDA; some accidental and some not so accidental.

    Image Credit (MorgueFile)

  • slide 2 of 4

    Where EBITDA Falls Flat

    Roll the Dice with EBITDA The financial accounting world is tricky and can be manipulated if need be. Flashy accounting can hide assets, income, losses, and other things from the balance sheet and income statement. A balance sheet can have its limitations and often what is doesn’t reveal is what an investor should be worried about.

    Because EBITDA considered sales revenues and not interest, taxes, depreciation or amortization, there can be problems with EBITDA.

    Enter the crafty bookkeeper or controller that understands the world of journal entries and debits and credits. Accounts can be easily raised or lowered as long as there is an off-setting journal entry and change the characteristics of the summary balance sheet accounts significantly. Sales may not look so high if expenses are cut or retained earnings or stocks accounts are changed. One who is analyzing and EBITDA report may also miss contra accounts and those are accounts that should not be missed.

    On the income statement side of things, another problem with EBITDA is increasing sales revenues but decreasing cost of sales (credit) and debiting some other account that won’t show up on the EBITDA financial report.

    If you’re an investor, it pays to ask for and review (in detail) the general ledger that shows all the adjusting journal entries and if you see something funky, you can make an inquiry.

    On the other side of the crafty bookkeeper or controller is the ineffective accounting person that fails to make proper journal entries that can also make an EBITDA report false.

    Image Credit (freedigitalphotos)

  • slide 3 of 4

    Why Experts Don’t Like EBITDA

    In an article from CBS Money Watch, E-B-I-T-D-A-Doesn’t Spell Cash Flow, writer Dev Strischek quoted financial expert Pamela Stumpp’s comment about EBITDA, that it is “A better measure for companies whose assets have longer lives, but it is not a good tool for firms whose assets have shorter lives or for companies in industries undergoing a lot of technological change.”

    Another problem with EBITDA is that it doesn’t really take cash flow management into consideration—something every business owner must master if they want to succeed. Most EBITDA financial reports emphasize earnings and compare those earnings to projects and beyond the tricky accounting, these reports don’t reveal where all the cash is going, unless the curious eye digs deep.

  • slide 4 of 4

    Be Cautious

    Be Cautious with EBITDA As a business owner and investor, I really see no purpose in using EBITDA because if you are monkeying with your books, it will be discovered. In additiona, sales projections for startups are really guesstimates until they have some history under their belt.

    If you are an investor and the business owner hands you an EBITDA report, tell the you have a problem with EBITDA only and ask to see detail; meaning a detail general ledger and sales and cost journals. The general ledger will have pretty much all you need to see and review including cash in and cash out, but the sales and cost journals will also reveal if sales look steep compared to costs; something any investor should be on the lookout out for if they’re considering investing in any company.

    Image Credit (MorgueFile)