Your Bonus. Is it based on EBITDA?

Credit: Synergy Marine

In the early 1980s as a teenager, I learned to race two-man Cadet sailing dinghies on the rehabilitated gravel pits in the Cotswolds, a beautiful part of the world, full of stone walled houses surrounded by green fields where I spent many of my English childhood years. My brother and I were dropped off at the sailing club after lunch on Sundays, rain or shine. Mum and Dad got a few hours off from the kids while we were shoved into a fibreglass bathtub, held together by ropes and fabric.

It was miserable to begin with, being new and not knowing what to do. But as the weekends wore on, we began to work it out and soon discovered that we could take the lead in races by going very fast (good) but just as quickly we often suddenly ended up in the water (not so good) as our competitors sailed past. A strong straight-line performance was catastrophically let down by our failure to balance the boat. So it can be with a well-known measure called EBITDA.

EBITDA is what one might call a point of pivot. It is a well defined calculation, which in itself gives a feeling of relative certainty. However many suggest this certainty is misplaced and that, whilst EBITDA can be a performance metric, it totally ignores things which if taken into account would completely change the overall picture of the perceived success or value of the business. The naysayers will tell you that EBITDA measures speed but not stability. My brother and I were fast but…..

The Real World

I asked the CEO of a successful young business what she thinks of EBITDA and she looked at me blankly. I briefly explained what EBITDA stands for and she shrugged her shoulders and said that her “finance people manage that sort of stuff”. My finance jaw hit the floor; surely a CEO of her standing lives and breathes EBITDA? Apparently not...

Earnings Before Interest Taxes Depreciation & Amortisation (E B I T D A). Do you care? Should she care? Do you understand what it is used for?

Business schools teach it. Business analysts talk about it. Financially-trained business managers often quote it, especially when the outcome is good, perhaps less so when it’s bad. Finance people calculate it easily; after all you just take the last figure in the Profit & Loss Statement (Profit after Tax) and add back x4 things - Interest, Tax, Depreciation and Amortisation.

In this article, I will open your eyes to why investors like to use it as a tool to measure underlying value within the business, and yet also show you how EBITDA used alone can seriously mis-value the business. We will discover how EBITDA is used as a performance measure for managers, and perhaps more interestingly how managers are able to manipulate the result, in their bonuses’ favour.

Lastly, given that you then understand it better, I will raise a thought in your head about what is missing in the EBITDA debate. This will enable you to have a conversation with others that will show you are a little more aware than most of what you are talking about.

So why do those in the know take EBITDA seriously? What does this measure really indicate to them?

Business Investors

Investors are trying to understand the underlying dynamics of an enterprise to decide whether or not to risk some of their precious funds in the business.

By looking at historical EBITDA trends, an investor can suggest whether the trading performance of the business is strong or weak. The strength of the indicator is that it ignores a number of issues that are largely outside of the day-to-day management’s control. The elements removed are

Interest: often relates to long-term loans that may well have been approved at a level above the senior manager (e.g. Board, Owner). Taxation: set by governments and very few decisions by management are able to significantly impact the charge in the period.

Depreciation & Amortisation: reflection of decisions to buy assets that were made many moons before the current performance period.

EBITDA highlights the trading performance of a business and purposefully ignores the capital structure of the business.

Seems eminently reasonable, doesn’t it?

Only considering EBITDA ignores out a number of key elements that make up the final net profit number and ignoring these completely could lead to disastrous conclusions if used for an acquisition or to grant management bonuses. Let us look again at the areas that are left out:

Interest - what if the Earnings number is positive and perhaps large ($15 million) but crucially less than the interest payable over the period ($18 million)? You have a shortfall of $3 million.

Tax - many businesses collapse when the tax authorities eventually come calling for their dues and add significant amounts of interest and penalties for late payment.

Depreciation - it is historic. What really matters is whether the business will generate the same Earnings in future with the existing assets. If not?

Performance Measure

Owners often use EBITDA as a performance measure with which to incentivise their business managers. On one of my international interim CFO assignments, our business unit was given an EBITDA target at the outset of the trading year by Head Office which seemed to me to be astronomical. Being an interim consultant, I was not part of the company bonus scheme so looked on dispassionately, wondering how on earth the management team could possibly accept such an outrageous stretch over and above what they had already achieved in prior years. By the end of the year, I had been given an in-depth insight into what muddy waters a bonus incentive can create. It was a whole business of its very own, akin to US political arguments over postal voting.

Let’s start with the definition of the make up E for Earnings, and how it can be affected by fundamental accounting rules. Revenue: If you sell something in the period, how much of the income is recognised? Well, it depends, doesn’t it? If you sell a service within the period then all of it, simple; but how about if you sell a long-life asset and agree to continue to look after it for the next 10 years? Well some of the income is recognised now, some later. How much? Well that depends, on a lot!

Costs: Everything you spend is a cost, right? Yes correct. But do all costs make it into the expenses part of the Earnings calculation. No, no, no.

We all know that capital investments are not part of earnings, they are instead capitalised on the balance sheet and then written off over their useful lives, in the form of…..Depreciation! Is that part of EB(efore)ITD(epreciation)A? The hint is in the B. Of course not. So the cost of an asset which is purchased in order to generate revenue is not included in EBITDA? Goodness me!

Consider the age-old accounting concept of accruals, where a cautious finance manager takes account of some potential costs in the trading period, even though they have not yet come home to roost. Very sensible, prudent accounting behaviour one might say. BUT..., if in a future period these expected costs do not show up, then they MUST be returned, in the following period, thereby moving the profit from one period to the next one, quite legitimately. So what does a sensible business manager do, knowing he is being assessed on his EBITDA delivery? In periods when trading performance is better than targeted, the manager thinks long and hard about all possible costs that s/he can reasonably suggest might emerge (e.g. pensions, staff bonuses, government levies) and makes an accrual for them, reducing his profits - very prudent.

Of course, not every period is a good ‘un, we all know that. However staff morale has come to rely on that Christmas Bonus. So in leaner times, it is very helpful for business managers to suddenly discover that they have over-provided for some of these costs in earlier periods and now can release them, creating a positive enhancement to Earnings in an otherwise down period.

Head Office was OK with it because they could continue to tell the investors good news. It was quite transparent to those in the know, but totally opaque to those outside of the inner circle.

Performance Measurement Issue that is excluded by EBITDA alone

• We have discussed the loopholes that allow ‘sensible’ management to manipulate the EBITDA numbers to reach the business’ desired outcome.

• We have seen that EBITDA removes the impact of certain decisions that are often made above management level (e.g. Capital Expenditure).

There is another key ingredient that is very much in management’s control, involving day-to-day trading decisions and is called Working Capital, the lifeblood of every enterprise. Working Capital decisions are made around collecting what it is owed from customers and then using these funds generated to buy more stock and pay creditors as their debts fall due. EBITDA is the starting point but does not take into account Working Capital at all, which tells everyone how stable the business is, and how safely it will be able to carry on trading into the future. Ignoring Working Capital in either a business valuation or a management team's bonus calculation seems to leave an open goal for potential confusion and could lead to a wrong decision.