NEW YORK-A senior executive of Moody’s Investors Service Inc. has issued a stern warning to securities analysts that a widely used measure of financial health is misleading and inadequate, particularly in industries subject to technological change.
Earnings before interest, taxes, depreciation and amortization, or EBITDA, “has lost meaningful purpose and thoughtfulness behind it, but has proliferated as a benchmark, despite its shortcomings,” Pamela M. Stumpp said.
“[Leveraged buyout sponsors] and bankers prefer EBITDA for its obvious image enhancement because it creates the appearance of stronger (debt) coverage,” she said.
Consequently, the watchdog agency for bondholders plans to issue debt ratings press releases that include “counterparts we think are more apt when we think EBITDA is inadequate,” Stumpp said at the recent New York Society of Security Analysts “High Yield Bond Seminar.”
Foremost, the debt rating agency will increasingly emphasize gathering frequent reports from companies on their sources and uses of capital. Moody’s also is alert to “tricks companies use to mask liquidity crises, like large draw-downs of credit facilities and madly capitalizing items,” she said.
Stumpp is a senior vice president of Moody’s, a senior ratings committee officer of its Corporate Finance Group and a member of Moody’s Standing Committee on Liquidity and Confidence Sensitivity.
“EBITDA should not be construed as a surrogate for net income or operating cash flow,” although it has assumed the false mantle of an equivalent to cash flow, she said.
“EBITDA is insensitive to the actual collection of cash reflected in operating cash flow, and a material gap in the age of receivables widens the gap between expenses and earnings.”
The benchmark also is a near-worthless measure of companies whose so-called “unusual charges” for actions like “asset improvements and merger and acquisition costs” actually are frequent rather than rare, Stumpp said.
Furthermore, EBITDA fails to consider the amount of required reinvestment, especially for “companies with short asset lives or companies experiencing technological change.”
Short-term capital investments, especially in equipment whose useful life is uncertain, should be counted all at once as an operating expense, not parsed out over a long period of time in small increments against the bottom line, as is done for capital expenses.
“EBITDA also creates distortions when subscriber attrition necessitates continual reinvestment,” she said.
In a related matter, Stumpp advised securities analysts to consider fully the accounting standards a company uses. This is particularly true for evaluating businesses domiciled in countries where the rules are less strict than American Generally Accepted Accounting Principals.
By way of example, she cited Celumovil S.A., a Colombian cellular provider. Under Colombian accounting principles, the carrier in 1998 capitalized over 20 years its expenses associated with start-up sales and marketing costs.
Following this system, the operator claimed EBITDA for the first six months of that year in the amount of $72.7 million. Under U.S. GAAP, which requires those costs to be counted as expenses, EBITDA for the same period was $13 million, Stumpp said.
“EBITDA tests (also) can be manipulated by the timing of asset sales,” she added.
“Paging companies are known for this because they can mask declining revenues by selling large volumes of used pagers and recognizing the revenues. EBITDA does not discriminate between revenues from the core business and other kinds of revenues.”
