How EBITDA Can Mislead

How EBITDA Can Mislead

I read with some amusement a post on Thursday 19 November on the Harvard Business Blog. Entitled “How EBITDA Can Mislead”, it demonstrates the rut traditional accounting measurement is in, while allowing the benefits of real value-adding Lean accounting measurement to become apparent.

The blog post authors highlight two issues without realising the true implications of what they are saying. The first is that manipulation of numbers for short-term window-dressing purposes has been going on for a long time:

In the mid-nineties when Waste Management was struggling with earnings, they changed their depreciation schedule on their thousands of garbage trucks from 5 years to 8 years. This made profit jump in the current period because less depreciation was charged in the current period. Another example is the airline industry, where depreciation schedules were extended on the 737 to make profits appear better.

So people switched their attention to EBITDA and guess what happened?

When WorldCom started trending toward negative EBITDA, they began to change regular period expenses to assets so they could depreciate them. This removed the expense and increased depreciation, which inflated their EBITDA. This kept the bankers happy and protected WorldCom's stock.

The second issue is that EBITDA still needs to be interpreted in light of other information to give real guidance:

Because EBITDA can be manipulated like this, some analysts argue that a it doesn't truly reflect what is happening in companies. Most now realize that EBITDA must be compared to cash flow to insure that EBITDA does actually convert to cash as expected.

The question I keep asking myself is when will accounting practitioners and analysts alike realise that cash flow and the key drivers of the changes in cash flow are a better indicator of the true health of a business? Anyone who wants a company to be profitable wants it to be so to enable further investment (growth) or dividends (return on investment). Neither of these are possible without cash.

What is the primary measure in Lean accounting? I’m sure you won’t be surprised to discover it is cash flow. Lean accounting focuses on an organisation’s value streams and drivers of cash flow within those value streams. Profit follows from generating cash – not the other way around.

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