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Brief Overview of EBITDA as a Credit Analysis Tool
There is much to be explained about EBITDA calculations inasmuch as profits are reverted to higher values. Whereas EBIT (Earnings Before Income Tax) merely disregards the tax provision for the annual income, EBITDA, or Earnings Before Interest, Taxes, Depreciation & Amortization, intends to project more in terms of profitability.
First off, this tool for analysis is not recommended for every financial statement user, because it was actually conceptualized by banks not for investment analysis but for purposes of determining their credit risks for high-end financing ventures. Accordingly, creditors--particularly banks--originally used EBITDA as their leverage in assigning lower loan values for the high-priced assets of distressed companies. This way, foreclosures, if any, would yield considerable compensations in return for the high-risk they undertook.
Secondly, dispensing with the valuation tools is against GAAP rules or even against the basic accounting principles of conservatism and materiality.
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How to Calculate EBITDA
This credit implement is calculated by simply adding back income tax, depreciation, and amortization expenses, and removing the interest earned by a company’s bank deposits. To illustrate fully, we will use the following givens:
- Revenue from Sales - $272,000
- Other Income- Interest on Deposits - $3,000
- Cost of Goods Sold - $55,000
- Gross Profit - $220,000
- Operating Expenses - Cash $122,800
- Depreciation - FFE $12,800
- Amortization - Leasehold Improvements - $7,400
- Net Income or EBIT - $77,000
- Income Tax Payable - $4,800
- Net Income for the Year- $72,200
Based on these givens, EBITDA calculation is as follows:
Net Income for the Year- $72,200
Add: Income Tax - $4,800
Add: Depreciation - $12,800
Add: Amortization - $7,400
Less: Interest Income - $3,000
EBITDA = $ 94,200
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The Premises for This Computation:
Add: Income Tax Provision
Proponents of this concept merely expounded on the EBIT premises, in which the income tax for the reported earnings is technically ignored. Most creditors use EBIT since the amount of tax reflected is still arguable and subject to IRS assessments. See a separate article entitled How to Calculate EBIT for more details about this concept.
Add: Depreciation and Amortization Expenses
Under the EBITDA concept, the objective is to gauge the results of business operations on a purely cash basis. Depreciation and amortization expenses are mere valuation entries and represent the expense portion of a capitalized expenditure as a way of matching income and expenses.
Lenders may consider the borrower's argument that these are expenses that will not affect their future cash positions. The original accounting entries used to set up the capital expenditure had previously recognized the reduction in their cash as a past transaction. To consider it as future cash reductions creates a redundancy in reducing their liquidity. Hence this concept adds back depreciation and amortization expenses to the income, for purposes of determining a more realistic cash position.
Less: Interest Income on Deposits
That being the case, interest income earned on the borrower’s bank deposits is disregarded, inasmuch as it is also arguable as an addition to future cash positions. Interest income amounts are reliant on the amount of deposits; and should the bank grant a substantial loan, part of the future interest credits will be based on the loan proceeds, which will form part of the borrower’s deposit balance. Thus, past interest credits should be disregarded as well; hence, they are deducted from the present earnings.
However, the reader is reminded that creditors use this concept only for credit risk analysis and not for reportorial purposes, since the arguments and premises involved do not conform to SEC’s GAAP rules.
Please continue on Page 2 for more on EBITDA Calculation
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Find in Page 2 of this article by Ciel S. Cantoria an example of EBITDA calculation and how it is used in credit analysis. In discerning the example, stock speculators will understand why EBITDA is not recommended as a basis for determining investment risks. Investors do not have the same privileges extended to creditors when it comes to recovery of investment exposure.
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Why EBITDA is Not a Tool for Investors
EBITDA is not recommended as a financial analysis tool for investors since investors assume different types of risks than those faced by creditors.
- Creditors consider other factors before granting credit; they do not rely purely on financial statement analysis. They can require collateral to serve as fallbacks in case borrowers renege on their promises to pay. Investors, on the other hand, only have stock certificates, which they can sell or divest any time without any assurance that they can recover their investments in full.
- Creditors have first priority over the assets of the company in case of insolvency or dissolution, and this privilege is supported by a deed of mortgage that specifically names the asset they can claim. The investors’ stock certificates give them rights to the company’s assets only after the creditor’s claims have been fully satisfied. In fact it is even doubtful if the former can even claim anything at all if the company goes bankrupt.
- Creditors can impose high interest rates in order to recover their investments at a more rapid pace. Stockholders cannot impose conditions for dividend earnings except for holders of preferred stocks with call dates and redeemable options.
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Example of Lender’s Credit Risk Analysis
Supposing a $200,000 loan payable in 5 years is granted at an interest rate of 6% p.a. and the projected monthly loan amortization is $3,896.66. The amortization represents a $3,333.33 monthly reduction in principal and $563.33 as interest income in favor of the lender.
If after two years of operation the borrower becomes bankrupt, the creditor at least will be able to recover as much as $93,519.94 ($3,896.66 x 24 months) through loan amortizations. If interest had not been not imputed, the amount recovered could be $79,999.92 only.
The rest of the lender’s claims, including penalty and past due interests and other expenses, can be recovered by foreclosing on the collateral.
Investors do not have the same kind of recovery options or fallback when investing money in a company, regardless of the amount invested.
Creditors use EBITDA calculations only as a gauge for measuring their credit risk and for determining up to how much of this risk they are willing to take. The matter of credit history and credit score can still negate the results of a financial statement analysis, notwithstanding the results of the borrowers’ cash position based on EBITDA.
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Analyzing EBITDA and a Poor Credit Score
If, for example, the EBITDA computed earlier will be the consideration for the proposed $200,000 loan but the borrower’s credit score is less than 500, there are serious issues that need threshing out.
Based on our computation, the company’s EBITDA is $94,200; if we divide this for 12 months the company earns a rough estimate of $7,850 monthly as unencumbered funds. This means that the projected monthly loan amortization of $3,896.66 is adequately covered by the borrower’s monthly earnings.
However, since the credit score is low, it is an indication that the borrower’s repayment ability is quite slow. The borrower has other debts to consider, i.e. trade payables to suppliers, and defaulting on them will not be good for the business either. This means that the remaining EBITDA after the projected monthly loan amortization has been applied is as good as compromised. Although the result of the EBITDA analysis is positive, there is very little room provided as allowance for contingencies. This is indicative that the borrower is a high credit risk.
Obviously, investors can expect very little or no return on their investment at all in a scenario like this because most of the business earnings will be used for debt repayments. Unless the investor goes into this same kind of analysis, an EBITDA calculation cannot be taken at its face value as a measure of profitability.
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Reference Materials & Image Credit Section
- Investopedia.com A Clear Look At EBITDA-- http://www.investopedia.com/articles/06/ebitda.aspby Ben McClure
- Old School Value.com EBITDA or FCF to Measure Cash Flow Apr 6, 2009 --http://www.oldschoolvalue.com/valuation-methods/ebitda-fcf-measuring-cash-flow/