Month: March 2013

This article was originally published on CoreEarnings.com .

What is EBITDA?

EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) is a commonly used earnings metric in financial analysis. The central motivation for using EBITDA is that shows a firm’s earnings from its core business activities and it is more of a cash based metric.

The first thing to note about EBITDA is that it is a ‘pro-forma’ measure in that it is not an earnings measure sanctioned under generally accepted accounting principles (GAAP). Therefore http://getzonedup.com/ EBITDA does not appear on an Income Statement and is instead calculated by the firm (or analysts) and reported separately.

The US accounting standards board (FASB) has a strict definition for calculating EBITDA which is adding back only tax, interest, depreciation and amortization to Net Income as reported on the Income Statement. However, most firms choose to report ‘Adjusted EBITDA’ or ‘Sustainable Earnings’ in their earnings releases. These measures and non-standard and vary from firm to firm making comparisons difficult. Typically, in addition to the standard EBITDA adjustments, these measures will also add back items deemed as ‘non-recurring’ such as asset writedowns.

Myth : EBITDA is Cash Earnings

EBITDA is often used interchangeably with cash flow , however it is definitely not a purely cash measure. Whilst some non-cash items such as depreciation are excluded, the earnings element in EBITDA is still based on the accruals concept and so revenue can be recognised even when the cash has not yet been received. If cash earnings are required for analysis, there is already an item in the standard GAAP accounts  – Cash Flow From Operating Activities that is the cash amount earned from a firm’s core business. EBITDA is thus a strange hybrid of an accruals based and a cash-based earnings measure.

It is also difficult to find a convincing rationale for excluding many ‘non-cash’ items such as depreciation. The motivation for removing depreciation and amortization is that they are non-cash expenses. However this is very misleading, the asset which is being depreciated was originally purchased with cash and excluded as an expense on the basis that the asset can be used over several years and so only a proportion of the cost should be included as an expense each year. In the same way, asset impairments and writedowns are based on previous cash payments.

Myth : EBITDA is Sustainable

A common argument for using measures such as EBITDA is that they exclude one-off charges such as asset writedowns which do not recur. This logic has some merit if a company seldom has such charges but the reality is that ‘one-off’ charges are often frequent occcurances for some companies (such as Hewlett Packard) and are indicative of a core issue with the business (such as the inability to generate organic growth and a poor acquisition policy in the case of HP). Therefore excluding these charges would give a misleading impression of the company.

Why the Popularity of EBITDA?

The main proponents of EBITDA and especially its derivatives such as Adjusted EBITDA are the reporting companies themselves. Using EBITDA measures allows firms to ignore a wide variety of costs and expenses and so flatter the business.

This article was originally published on CoreEarnings.com .

In its offering prospectus Groupon billed itself as a ‘local e-commerce’ company which brings ‘the brick and mortar world of local commerce onto the internet’ which clearly defines it as an online tech business.

It is therefore nothing less than astonishing to see no Research & Development expense on the company’s Income Statement. Other companies in the internet/technology space maintain their R&D expense at a fixed percentage of Revenue. The below chart shows the 2012 Q4  R&D / Revenue ratio for several major internet/tech companies :

Most companies have an R&D / Revenue  ratio of between 0.1 – 0.2, Apple is the outlier with only 2% of Revenue spent on R&D, which is partly due to its huge Revenue allowing it to still spend a large absolute amount on R&D yet keep the percentage low and also it essentially outsources its R&D to suppliers.

In addition to being a large expense for a tech company R&D is also kept at a very consistent percentage of https://hotcanadianpharmacy.com Revenue over time, this is a clue to just how important of an expense R&D is. The below chart of R&D/Revenue over time for some of Groupon’s ‘peers’ shows how consistent the ratio is kept.

It is possible this is simply an issue of attribution and Groupon’s R&D-type expenses are included under another heading such as ‘Selling, general and administrative’ however Groupon’s filing make no mention of research type activities being included in other expense headings.

Capital Expenditure

The first place to look for missing expenses is the Cash Flow Statement to see if it has been capitalized instead of expensed. Capital Expenditure is similar to R&D except that Cap Ex leads directly to the creation of a valuable asset (which can be software) whereas R&D is more general research which has not yet led to the creation of an asset. In terms of accounting, R&D is charged directly against Revenue to arrive at a firm’s profit, whereas Cap Ex is not charged against Revenue and instead creates an asset on the Balance Sheet. 

Thus, it can be advantageous for a company to classify R&D as Cap Ex although this is considered at a minimum an aggressive accounting practice. Groupon’s accounting policy is to treat all of its software development as Cap Ex which is a sound policy consistent with accounting policies of some other internet companies such as Amazon. Nevertheless with all of the software development being charged to R&D it remains a concern that not enough is being expensed on the Income Statement.

This article was originally published on CoreEarnings.com 

Financial Reporting is primarily focused on providing a detailed view of a firm’s earnings. The accruals concept is applied to both revenues and expenses so that only income/expenses which are earned or occurred in the period are reflected in the accounts irrespective of payments. For example, a software firm which pre-sold licenses for software which has not  yet been delivered and collected payment would not  recognise the sale in its accounts until the software was fully delivered.

The accruals concept is intended to provide a truer picture of a firms financial performance, however it has the drawback of earnings diverging from the cash generated by the business. The core concept is that earnings will eventually show up as cash flow.

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The issue with earnings  measures such as Net Income is that they include items such as depreciation and provisions of bad debts which require estimates and so affords the business a degree of latitude in ‘managing’ its earnings.  Cash Flow is a harder measure which must must backed up by movements in the firm’s cash balances which is straightforward to verify. Thus to aid the understanding of financial performance a Statement of Cash Flows is included in financial reports.

The most important item in the Cash Flow statement is the Cash Flows From Operating Activities which shows the cash generated by the firm’s core business activities.  It is arrived at by starting with Operating Income and adjusting for all non-cash items. In financial analysis, capital expenditure is sometimes deducted from Cash Flow from Operating Activities to arrive at Free Cash Flow. The rationale for deducting capital expenditure is that this is a necessary recurring expense for the firm to generate its income.

There are two other balances in the Cash Flow statement – Cash Flow From Financing Activities is the cash movement associated with the financing of the business so issuance or repayment of loans as well as equity issuance will be shown in this balance. Cash Flow from Investing Activities relates to investments the firm may make in securities as well as investments in fixed assets.

 

Use of the Cash Flow Statement

For a business or financial analyst the primary use of the Cash Flow Statement is in determining the quality of a firm’s earnings. As noted above, a firm’s earnings should eventually be reflected in the firm’s cash flow. Thus Free Cash Flow (or Cash Flow from Operating Activities) should trend with Operating Income, note from the below chart that Apple’s Free Cash Flow closely tracks its Operating Income:

A prolonged divergence in these series could signal aggressive accounting to artificially boost Income.

Cash Flow Statement Limitations

A common misconception is that cash flow is immune from manipulation since the firm must verify the actual movement in its cash balance with bank statements. However, this is only true for the total movement in cash flow, the Cash Flow From Operating Activities balance can easily be manipulated by misclasifying items which should ordinarily be expensed. For example, WorldCom misclassified operating expenses as capital expenditure, which has the effect of removing the expense from both the Income Statement and the Cash Flow From Operating Activities, instead the amount showed up in the Cash Flow From Investing Activities which is less used by financial analysts.

Finally, note that Cash Flow is not the same as EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) although financial reports sometimes use the two the interchangeably. EBITDA still use the accruals method to arrive at the earnings figure which is then adjusted for non-cash items such as depreciation and amortization. As such EBITDA is a hybrid between a regular accrual based earnings measure and a cash based measure of earnings.