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Bottom line ebitda bumf misleads investors

By Alan J Robb

Friday 1st September 2000

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In the wake of the Advantage Group debacle it is heartening to learn both the Stock Exchange surveillance panel and the Public Relations Institute have warned companies and PR consultants about the release of financial results (NBR, August 18).

A key concept that must be addressed, if investors are not to be misled, is ebitda (earnings before interest, tax, depreciation and amort-
isation). This was an integral number in the Advantage release and also in that from Sky Network Television.

It is not, however, a term recognised in accounting standards or in Stock Exchange listing requirements; both of which are designed to provide standardised, useful information for shareholders.

Ebitda is a creation of some US analysts. It has little validity or relevance especially in the New Zealand financial reporting environment. It is a mutation of ebit (earnings before interest and taxes) and like many mutations it distorts the original from which it is derived.

Ebit was a measure designed to facilitate a comparison of profitability, irrespective of the way in which organisations are financed or taxed. It allows the achievements of operating managers to be seen independently of factors outside their control.

Such factors might be financing decisions (made by the board) or changes in tax payable (whether from changes in tax rates, losses carried forward or incentives granted by the taxing authority). By calculating the ratio of ebit to sales rather than profit after tax to sales, it is argued, a better picture of the profit performance achieved by operating managers is presented.

So what does ebitda attempt to show?

Most US sources say ebitda shows the operating cash flow. This perpetuates a long-discredited fallacy of US accounting, that cash flow equals net profit plus depreciation. In the days before a statement of cash flows was required this fallacy was repeated without its emptiness being seen.

At best it could have been called a surrogate for operating cashflow. Today it is obvious, to those who look, that it is a poor surrogate.

The statement of cash flows shows clearly the operating cash flow together with the investing and financing flows. There is no need for any surrogate.

The table shows how ebitda has repeatedly exceeded the operating cash flows for Advantage and for Sky for the past two years.

Advantage's operating cashflow actually deteriorated four-fold rather than apparently improving 140%. In contrast, Sky's actually improved 150% instead of being virtually constant. In neither case does ebitda show fairly what the operating cash flows have been.

The companies themselves contribute to the confusion of ebitda and operating cashflow in the way their results have been released to the media.

Sky's two-page media release of August 14 emphasised a marginal growth of "Sky's operating cash flow ... reaching $74.1 million compared with last year's $73.7 million." But in a separate one-page "full-year report" it referred to the $74.1 million as being "operating cash flow/ebitda." It was only when one received the material supplied to the Stock Exchange as appendix 1 that the real operating cash flow of $59.57 million was seen.

In its media briefing Advantage highlighted its growth in ebitda from $4.0 million to $9.7 million. It did not disclose the actual operating cashflow deficit of $2.4 million until it was forced to file its appendix 1 statement with the exchange two days later.

Perhaps one can see here why Michael Vick, a US commentator, recently observed ebitda is on the lips of analysts everywhere. "And why not?" he asked. "When your job is to recommend a stock, and there are no other reasons to recommend a stock, you better say something. So just say E-bit-Da."

Ebitda does not measure profitability; it is not a surrogate for operating cashflow; it has no redeeming features. I invite the Stock Exchange and the Public Relations Institute to take a stand for better financial reporting and say publicly it will be unacceptable for their members to report ebitda in future.

Alan Robb is a senior lecturer in accountancy at the University of Canterbury. He holds no shares in Advantage Group or Sky Network Television

HOW EBITDA EXCEEDED CASHFLOWS

Ebitda Actual operatingEbitda Actual operating
1999cashflow 19992000cashflow 2000
Advantage$4.0m-$650,000$9.7m-$2.4m
Sky Network$73.7m$23.76m$74.1m$59.57m
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