Yes, it is also like that in continental Europe, as far as I have seen, but it doesn’t imply that people use it as cash flow.
Net Debt / EBITDA of 2 is less speculative than Net Debt / EBITDA of 5. I see it only as a indebtment measure per unit of some sort of economic strength.
I think it does imply they use it as cash flow – because why else would anyone look at EBITDA? It’s not a proxy of sales, profit or assets. The closest thing it’s a proxy to is cash flow even though that’s flawed.
Banks lend based on asset or net asset (equity) coverage and cash flow coverage of which EBITDA is the metric. I have never seen a bank covenant based upon free cash flow or cash flow from operations.
The misunderstading seems to be endemic. Some really large portion of professional managers who should know better think they should be valued at “8x EBITDA because that’s what is fair” and other nonsense like that. Oh it’s fair? Is it fair to me that you’re destroying capital with pointless capex and 80% of your EBITDA is DA? No it’s not.
I am short one company that is destroying capital at 12x EBITDA (in line with peers!) that has never had positive FCF and where the EBITDA is almost entirely DA. They don’t now and probably will never make money and people are going to figure that out eventually.
Don’t be hating on EBITDA as a measure for lending, bras. It is a robust measure of profitability that shows a company’s true earnings potential in a fashion which maximizes comparability between your lending target and industry benchmark groups. Unlike CFO/FCF, it is independent of the company’s current financing and it excludes certain items which tend to exhibit a higher degree of variability among companies - working capital management, CAPEX investment and depreciation schedules. Management typically has the ability to pull WC and CAPEX levers and manage their FCF on a short-term basis much more so than they are able togame their cost margins to inflate EBITDA.
Would you rather lend to a company that has low EBITDA margin compared to its peers, but decent FCF because management spends minimum CAPEX to cover maintenance only, and operate with zero or even positive change in WC? Or a company with strong EBITDA which has been consuming WC because it is growing and had a high CAPEX outlay because of their expansion/new business investments? Certainly any lending agreement would curb that by putting limits on spending to make sure the debt can be serviced (I’ve never seen one without CAPEX covenants), but EBITDA is a great starting point when considering lending targets.
In summary, you obviously can’t look at EBITDA in isolation but it is certainly not just used as dumb-down proxy for CFO - it carries important information on its own.
It depends. Like I said in an above post, EBITDA can be a pretty good proxy under certain circumstances.
But if the company is aggressively growing (and therefore consuming cash in working cap), has real cash taxes, high interest expense, and capex > DA it is a ridiculous metric to use for cash flow. It’s also an absurd metric for companies that have nearly 0 EBIT but high EBITDA.
However, I can’t agree that EBITDA shows a company’s true earnings potential because interest and taxes are real cash expenses, and something is wrong or at least unusual if the DA > capex over time. So EBITDA persistently overstates true earnings potential in most cases.
I think the value of EBITDA in lending covenants is that it provides a convenient benchmark to compare among peers (as you said) that also provides a directional benchmark – i.e., is it going up or down and at least meeting some minimum threshold? Whatever the reason though, it is the standard.
BTW, I feel really dumb asking this, but I have always strugged to understand working capital… is it simply stuff on the balance sheet that is used as productive assets but can be liquidated quickly if a project is canceled or scaled down? As a macro guy I don’t really deal with WC that much, but I wish I had a better grasp of it.
I seemed to be able to answer the CFA questions that involed working capital, but I never really felt that I had a good intuitive understanding - I felt more like I was just cranking the formula and had done enough problems not to make too many mistakes.
What I mean is, how is working capital different from other forms of capital? Is it just more short-term than traditional fixed assets? Mostly what I have problems with is what are the events that turn stuff into working capital and turn it back into cash or whatever else it turns into when it’s “released”. What is it that is special about “working capital” that is different from ordinary assets/capital?
EDIT: Maybe part of the issue is that there’s an accounting definition of working capital (Cur Assets - Cur Liabilities). Then there is a corporate finance definition of working capital (stuff bought to enable a project to go forward which is “releasable” for other corporate uses or liquidation when the project finishes). I’ve tended to think of working capital more in the CorpFin way than in the accounting way. Is there a relationship between the two? Or is it just two things that have the same name?
Lenders get repaid from cash flow not EBITDA. I think EBITDA’s biggest weakness is its failure to take into account working capital items. You can have two companies with the exact same EBITDA and the exact same capex, but one could be on the verge of bankruptcy because all its sales were on credit (just pay me later as long as I get to record a sale and increase my precious EBITDA). Low and behold, the Company fails because its receivables are through the roof and it has no cash to pay its lenders. But look at its EBITDA!!! The Company could be in compliance with all its lending covenants.
The only time I would use EBITDA is if the working capital items have been fairly stable/no meaningful changes (mainly accounts receivable, inventory, and accounts payable).
I’m just saying whether you can use EBITDA or not depends on a lot of factors. I’m not saying I’ve never used it to value a company. I just don’t use it blindly like most of the rest of the market does.
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“I seemed to be able to answer the CFA questions that involed working capital, but I never really felt that I had a good intuitive understanding - I felt more like I was just cranking the formula and had done enough problems not to make too many mistakes.”
Welcome to the entire CFA program… OHHHH SNAP. I distinctly recall getting flamed out repeatedly on this forum for saying the CFA program is practically worthless – well guess what, it’s kind of a joke that someone could be a charterholder of the “gold standard” in the investment world and still not really understand working capital. I’m not picking on you bchad (because the program failed you), just saying the program is deeply, deeply flawed (but don’t worry, you know how to calculate a triple reverse upside down butterfly options spread, because that totally comes up all the time). Doin’ it for the lulz CFAI.
Anyway, to answer your question, this is how you should think about working capital from the perspective of an operating company (which is what most businesses are):
A company purchases fixed assets using various capital sources (debt, equity, preferred) and files these fixed assets under long-term on the balance sheet. There are also short-term assets such as receivables, inventory and pre-paid expenses. These represent cash outlays (you have to purchase inventory, you pre-paid the expense, and you have receivables for which you’ve provided some product or service but have not received the cash yet (this gets into accrual accounting which is a longer discussion)). You also have current liabilities like accounts payable where you owe people money (effectively someone else’s receivables).
By this definition, working capital represents the net cash invested in short-term assets in the business, which is typically abbreviated AR + Inv - AP but may include other items. If you have $5 of AR, $10 of inventory and $4 of AP, you effectively have $11 of cash “tied up” in operating the company on a day-to-day basis (tied up because the company isn’t going to run itself, you had to invest this cash, otherwise known as capital). It’s “working” capital because it’s distinct from “fixed” capital or fixed assets that don’t get “processed” (AR is collected, inventory is sold, whereas PP&E is effectively stagnant on the balance sheet except that it depreciates over time (AR and inventory don’t “depreciate”)).
If you want to look at a retailer (very simple business model) they essentially spend a bunch of cash on operating leases, buildings (PPE) and inventory (very low AR and AP for most). The buildings are fixed regardless of whether there is any inventory or customers are even allowed inside the building. The inventory however is the life blood of a retailer – they buy stuff, mark it up, and resell it with the difference effectively represented by their gross margin on the P&L (there can be some other non-product costs in here too). The “mark up” represents their cash gain on the cash invested in the inventory before accounting for other operating expenses. The retailer stays in business by consistently earning a reasonable cash / cash return on its inventory investments.
This is why a high gross margin retailer that is not moving its inventory and has to mark down its products can lead to some brutal earnings misses (and cash burn) and terrible stock blow ups (and is also one of the reasons that I religiously avoid most fashion apparel stocks).
So I guess if you wanted to look at it from a biology perspective, the working capital is the blood and the fixed assets are the body. The body doesn’t work unless it has something flowing through it, and that’s what working capital is.
The corp fin definition is different (note that everything in finance has at least 3 names and is designed to confuse you).
Very helpful, bromion. Thanks. I can see the difference between fixed capital and working capital now. It makes a lot of sense.
Also useful to know that part of the reason I was having trouble was that the Accounting and CorpFin concepts of working capital really are different. I think the big reason I was so confused was that I was trying to understand them as the same thing and not able to do it. Very frustrating because IIRC, in modeling you need to understand Accounting WC for liquidity issues, but CorpFin WC for capex purposes.
I didn’t find the CFA program useless, but it’s silly to expect it to be everything in all situations. For me, who didn’t do finance as an undergrad or didn’t do an MBA, it still filled in a lot of gaps that would otherwise need feeling.
I won’t beat a dead horse except this last comment, which is I think it’s useless because it’s so poorly calibrated (useless might be too far so I will say “practically useless”). It’s difficult to defend the content focus in really obscure areas like reverse cash and carry arbitrage, which is applicable to <1% of investment professionals, and not give due coverage to things like working capital, which is relevant to probably 80% of investment professionals. It’s just a really deeply misguided program that is not very relevant to real world application, but probably would be very appealing in an academic setting. As I’ve said before, it is the gold standard of nothing. I don’t even renew my dues anymore.
I think you understand it pretty well. Working capital is basically the stuff that is needed to operate a business regardless of capital structure (ex. receivables, inventories, payables, etc.). The working capital assets are a use of cash and the working capital liabilities are a source of cash. The different between the two is working capital. True working capital would remove excess cash from assets and debt from current liabilities since this is part of the capital structure…
@ thommo77, you are describing a serious operational issue that shouldn’t be overlooked, but more often than not can be addressed by identifying deficiencies in receivables and inventory management. If my goal is to improve cash flow, I would rather have a business with strong EBITDA and poor WC management record than one with weak EBITDA margins that preserves working capital.
Furthermore, the situation that you are describing where the receivables are through the roof and the company is running out of liquidity to service its debt - that’s not such end of the world scenario from a lender’s perspective! The receivables still serve as collateral coverage, and if the company defaults on a payment that really allows the lenders to take proactive steps in making operational changes and exercising their influence on management. Contrast this with a situation where you’re running out of cash cause your EBITDA is low even though you’re managing WC the best you can? Now you really might be on the verge of bankruptcy, and the lenders can expect pennies on the dollar!
I like the ebitda/sales ratio. It just seems like if a company’s sales are growing and ebitda/sales ratio is improving, then it will usually be good for the stock price. For example, if a company has sales growth and operating leverage, the ratio should improve. Or if a company uses FCF to fund acquisitions, a higher ratio post acquisition should suggest that they are creating value (but make sure EBIT is also inline).
For FCF calculations, I like to use OCF-MaintCapex, but also adjusting OCF for WC swings or other non-recurring lines. Never really got into the “unlevered FCF” definition.
sigh. I keep bookmarking bromion’s posts.
no homo.
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