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PITFALLS OF EBITDA
RELEVANCE
Earnings before interest, taxes, depreciation and amortization (EBITDA) is one of the most commonly used profit metrics
in today’s world of corporate finance. It is considered a proxy for operating cash flow and is often employed as an input
to measuring debt service capacity (e.g. Debt/EBITDA Ratio) and determining enterprise valuation (e.g. EBITDA Multiple).
While the use of EBITDA has become ubiquitous, it is also important to remember some of its pitfalls. When not calculated
correctly or applied in the wrong context, the use of EBITDA can lead to significant distortions and misleading financial
interpretations. This FAQ provides guidance on IFC’s methodology for calculating EBITDA and discusses some of the
limitations that investment staff should be aware of when using EBITDA in financial analysis.

GUIDANCE
1. What is EBITDA and how is it calculated? EBITDA is a measure that assesses the inherent ability of a business to
generate an economic surplus after covering direct and overhead costs. Therefore, a negative EBITDA should always raise
fundamental questions regarding a company’s cost structure and overall financial viability. As EBITDA is calculated before
the effects of leverage and taxation, it can be used to: (i) track the profitability of a company over time; (ii) compare the
profitability of companies in similar industries; (iii) serve as a starting point to evaluate a company’s debt capacity, and;
(iv) determine an enterprise value by using comparable multiples. IFC has adopted a bottom-up approach to calculating
EBITDA by adjusting net income by: (i) subtracting extraordinary gains, non-cash income and proceeds from asset sales,
and; (ii) adding back interest, taxes, and certain non-cash expenses such as depreciation and amortization1.

2. What is the difference between EBITDA and Cash Flow from Operations? EBITDA is sometimes considered a proxy for
Cash Flow from Operations. This is incorrect because EBITDA does not include the impact of taxes and changes in working
capital, while Cash Flow from Operations is net of these items. Also, Cash Flow from Operations adjusts for all non-cash
operating items, while most EBITDA definitions will only adjust for depreciation, amortization, and gains/losses from asset
sales and include items such as: change in biological asset value, allowance for doubtful receivables, gains/losses from
derivative transactions, retirement provisions, accrued taxes, etc. The difference can be very significant depending on the
type of company.

3. EBITDA ignores changes in working capital. Companies with similar EBITDA may have significantly different working
capital cash flow cycles (A/R + Inventory – A/P), and therefore, materially different risk profiles. Example A shows two
companies, with the same EBITDA of $100. However, substantial differences in their working capital cash flow cycle result
in operating cash flows which are positive $50 for Company A, but negative $45 for Company B. Such differences could be
driven by factors such as higher revenue growth driven by credit sales, slowdown in accounts receivable collection, or
increases in raw material prices, none of which is picked up by EBITDA. To the extent that Company B has excess cash,
access to equity or committed short-term working capital facilities to fund these working capital needs, this may not be a
problem. Otherwise, the negative operating cash flow of Company B raises questions regarding its fundamental viability.

1 IFC Definition of EBITDA: for any period for any person or specified group of persons, Net Income for such period (without giving effect to (x) any
extraordinary gains, (y) any non-cash income, and (z) any gains or losses from sales of assets other than inventory sold in the ordinary course of
business) adjusted by adding thereto (in each case to the extent deducted in determining Net Income for such period), without duplication, the
amount of (i) total interest expense (inclusive of amortization of deferred financing fees and other original issue discount and banking fees, charges
and commissions (e.g., letter of credit fees and commitment fees)) of such person or specified group of persons determined on a consolidated basis
for such period, (ii) tax expense based on income and foreign withholding taxes for such person or specified group of persons determined on a
consolidated basis for such period, and (iii) all depreciation and amortization expense of such person or specified group of persons determined on a
consolidated basis for such period.

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4. EBITDA ignores the need for non-discretionary capital expenditures (capex). Two companies with the same EBITDA
may have very different capex needs. Companies with discretionary capex (e.g. for an expansion or an acquisition) may
have flexibility in timing these expenditures to match availability of funds, unless the project is already under
implementation. However, companies with non-discretionary capex, such as for maintenance and refurbishment, need to
make these expenditures to keep operations going. EBITDA cannot differentiate between these two cases. In Example A,
both companies have an EBITDA of $100, but the non-discretionary capex for Company A is $100 compared to only $5 for
Company B. As a result, despite having positive cash flow from operations, Company A actually has the same liquidity
issues as Company B. Both companies need long-term debt, equity, or excess cash to fund their operations.

5. Is Debt/EBITDA a good measure of debt capacity? We often use a 3x Debt/EBITDA ratio as a rule of thumb for
determining a company’s debt capacity (assuming an average debt maturity of 5 years and 3 years for repayment). This
may be fine for a quick “back-of-the-envelope” assessment, but there are a number of important factors which the
Debt/EBITDA ratio will not pick up. First, the Debt/EBITDA ratio ignores the maturity schedule of a company’s long-term
debt, with the same Debt/EBITDA ratio resulting from debt with average maturity of 3 years or average maturity of 10
years. Second, the ratio does not distinguish between short-term debt (i.e. repaid through the working capital cycle) and
long-term debt (i.e. repaid from discretionary operating profits). Third, Debt/EBITDA ignores the cost of debt and treats
high interest debt exactly the same as low interest debt, even though this obviously can have a significant impact on debt
service capacity. Finally, (and as described above), EBITDA is not a measure of discretionary cash flow available for debt
service, as it ignores taxes, mandatory capex, and working capital changes which may need to be funded from operating
cash flows. Some countries also have mandatory statutory distributions to workers and/or shareholders, which may
reduce available cash for debt service. Overall, while the Debt/EBITDA ratio has its value as a quick assessment tool, the
only definitive way of understanding debt service capacity is through a full financial model and the calculation of relevant
debt service coverage ratios.

6. EBITDA and the “Consolidation Trap”. When assessing EBITDA on a consolidated basis for a corporate group it is
important to understand in which entities of the group the consolidated EBITDA is generated. Example B shows a company
with consolidated EBITDA of $100, but in Scenario 1 all of the EBITDA is generated at the subsidiary level, while in Scenario
2 almost all of EBITDA is generated at the parent level. If the intention is to lend to the parent this would obviously be very
pertinent information, which will only be revealed when looking at EBITDA on an unconsolidated basis. It is also important
to remember that consolidated EBITDA will include 100% of the EBITDA generated by a company’s subsidiaries, even if a
company only owns 51% of its subsidiary (as illustrated in Example C). Consolidated EBITDA, therefore, ignores claims by
minority shareholders on the cash flows of the company.

7. What is the impact of different accounting principles on EBITDA? Accounting principles will differ across countries and
it is important for investment teams to carefully review the accounting policies applied by the company (in particular
revenue recognition, capitalizing vs. expensing costs (e.g. disguising ordinary expenses as capex), goodwill recognition,
fixed assets depreciation, treatment of deferred checks and asset sales, treatment of derivatives, results from biological
assets, etc.). Furthermore, EBITDA is not defined in GAAP, which gives companies some latitude in how they calculate it.
While definitions of EBITDA can differ, it is important that the same definition is used consistently for the purpose of
historical financials, projections and all valuation calculations (entry and exit).

8. Quality of EBITDA matters. EBITDA, as any measure of earnings, can easily be influenced by management decisions to
inflate the figure in the short-term, while jeopardizing the long-term viability of the company. For example, aggressive
cut-backs in marketing expenses, growth in revenues paired with increasing ageing of A/R, low reinvestment rate,
existence of high amounts of goodwill depreciation of acquired assets/companies with uncertain future value, asset sales,
large amounts of interest income from cash in hand, all may maximize EBITDA in the short-term, while sacrificing
sustainability of EBITDA in the long term.

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Example A:

US$ Company A Company B

Income Statement
Sales 200 200
EBITDA 100 100
Net Income 20 20
Cash Flow Statement
Net Income 20 20
Add:
depreciation 20 20
interest 15 15
tax 5 5
Less:
Increase in A/R 5 55
Increase in inventory 10 40
Decrease in A/P (5) 10
Cash Flow from Operations 50 (45)
Less:
Maintenance Capex 100 5
Expansion Capex 20 20
Cash Flow from Operations after Cape x (70) (70)

Example B: Where is EBITDA generated on an unconsolidated basis?

Example C: How much EBITDA “belongs” to the minority shareholders?

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CreditFAQ30: Published November 2013