The reference rate currently most commonly used in financial-economic analyses is the EBITDA (Earnings Before Interests, Tax, Depreciation and Amortization), which is understood as being the resources generated by a company in its operations during a financial year, which measures the pre-tax profitability, without taking into account any costs not paid, such as amortizations, depreciations and provisions.

The Spanish Accounting and Business Administration Association (Asociación Española de Contabilidad y Administración de Empresas) (AECA) has issued an opinion on the EBITDA presenting a proposal for a standard definition for calculating it.

In order to obtain this reference rate, the recommended method is an indirect one, adapting to the result of the financial year any costs or revenue which are not operating or recurrent: tax on profits, financial revenue and expenses, impairments and results the through disposal of intangible assets, allocation of subsidies, depreciation of fixed assets, depreciation and impairment of goodwill, negative difference of business combinations, work carried out by the company on its assets and exceptional result.

Economists are discussing the advantages and inconveniences of the EBITDA as a reference rate since, while in fact very useful, above all in the comparative analysis of financial profitability, it is not so much in other aspects. What is actually being questioned is its partiality as a reference rate and the abuse being made of it, especially in the valuation of companies through the system of multiples.

As we have said, the EBITDA does not take into account certain costs, including depreciations. This is one of the most disputed aspects which, in my opinion, recommend against it in companies operating in sectors requiring strong fixed capital investment.  For example: in a hotel, where the item of depreciations is essential on being an extremely important component of the costs in the operating account, carrying out a suitable investment policy for plant maintenance is not the same as not attending to necessary renovations in order for it to operate. If a company does not consider this cost in its analysis, it is making a mistake. It might have very high EBITDAs but might be decapitalising itself in the long term.

Another aspect of this item is the accounting policy adopted since, if we force repair or maintenance costs (plus depreciations) to be capitalised, we will have a high EBITDA. If, on the other hand, we record such costs more cautiously, the result will be lower. In other words, it useful for financial corrections when providing one figure or another, and there is a risk of transparency.

There is a ratio which derives from the EBITDA, namely: net financial debt/EBITDA. This ratio, also very commonly used, is far less useful than that of: total indebtedness/operating profit, as the latter includes entries necessary for calculating the level of true indebtedness.

Evidently, these are ratios which are useful per se, but what we are discussing in this article are the advantages and inconveniences of the EBITDA, and the prevention we should implement as regards its abuse when the party involved is more interested in magnifying the results than in showing the economic-financial reality in a certain period.

Moody´s published an article entitled “Putting EBITDA in Perspective” on companies in the USA, describing the 10 most important mistakes in the use of the EBITDA. There have been other publications and articles on the issue, although what is most important is the experience some of us have had in sale and purchase transactions of businesses valued using this ratio by an investment fund and the consequences resulting over time.

In this sense, it should be stated that what can be done in order to weigh up the advantages and inconveniences of the use of the EBITDA is to analyse the post-tax result in the Profit and Loss Account based on the EBITDA of the same account. Therein, we can clearly see the differences, and what sometimes happens is that the operating profit is negative and the EBITDA positive, and frequently, the difference between the two is highly significant.

However, we should not ignore this very useful ratio in benchmarking, but one thing is its use for analysis, and quite a different thing is to confer on it importance which it does not have, basically in the valuation of companies and businesses where, nowadays, it is more recommendable to use discounted cash flows.

Finally, we should state that the EBITDA is not legally regulated either by the Spanish General Accounting Plan or International Financial Reporting Standards (IFRS). If the intention is to use this reference rate, for the sake of the necessary credibility, it is essential to include sufficient information in order to reconcile it with the entries included in the standard Profit and Loss Account.

Ignacio Esteban, Auren Auditing Partner