Why You Should Never Ever Use Debt To EBITDA When Assessing A Company

Date: 31 Jul 2015

Although many analysts use Debt to EBITDA when assessing a company, I strongly discourage you NOT to use this measurement. Many companies use this measurement when they prepare their Summary Report for the quarter to paint a rosy picture. It DOES NOT.

EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortisation.

So you have to ask yourself these questions:

1) If a company borrows money from the banks, it must service the interest payment, right? Well EBITDA does not take into consideration of this cost. Isn’t it precarious that analysts completely ignore this when assessing the worthiness of a company to invest?

2) All companies have to pay taxes. There are various form of taxes not just the tax which a company has to pay when it makes a profit.

3) When you make a capital investment normal accounting practice dictates that you need to depreciate the asset over the lifespan of the asset. Not all assets will appreciate in price. Perhaps the only asset which does is property. So when a company makes investment in plant and equipment, these assets costs need to be depreciated over a period of time because they lose their value as time progresses. To not include depreciation in assessing a company is like trying to pain a rosy picture which is not.

Can you imagine many analysts use EBITDA to measure the earnings of many shale oil companies in the US? Oil companies invest the most in plant and equipment, to simply ignore this fact is at one’s own folly.

Warren Buffet said it better, “Does management think the tooth fairy pays for capital expenditures?”

4) Amortisation is the same as depreciation, but it is used on intangible assets instead, such as goodwill or patents.

So because Debt to EBITDA = Total Liabilities/EBITDA,

The higher the EBITDA, the lower the ratio, so it masks many potential problems within a company, such as when a company is operating at a loss after interest costs and depreciation. When this occurs, how do you think the company can afford to pay for the interest on its debts? The company borrows again, each time inflating its debts.

Many analysts who adopt Debt to EBITDA as a form of measurement are often cheating themselves or worse, the unknowing investors who rely on their expertise to guide them in their investments.

pc wong.

Leave A Response

* Denotes Required Field