EBITDA definition in theory and practice – When to pay special attention

What we normally think when we see the term EBITDA:

1) Revenue – Operating expenses + Depreciation and Amortization

or

2) Net Income + (Net) Interest Expense + Income Tax + Depreciation and Amortization

What the loan agreement says:

“Consolidated EBITDA” is a measure that reflects earnings before interest, taxes, depreciation, and amortization expense, and is further adjusted for, among other things, letter of credit fees, equity-based compensation expense, net gains or losses on property disposals, restructuring charges, transaction costs related to issuances of debt, non-recurring consulting fees, non-cash impairment charges, integration costs, severance, non-recurring charges, the gains or losses from permitted dispositions, discontinued operations, and certain non-cash expenses, charges and losses (provided that if any of such non-cash expenses, charges or losses represents an accrual or reserve for potential cash items in any future period, the cash payment in respect thereof in such future period will be subtracted from Adjusted EBITDA in such future period to the extent paid). Certain expenses that qualify as adjustments are capped at 10.0% of the trailing-twelve-month Adjusted EBITDA, in aggregate. Adjustments subject to the 10.0% cap include, but are not limited to, restructuring charges, integration costs, severance, and non-recurring charges. Additionally, all net gains from the disposition of properties are excluded from the definition of Adjusted EBITDA.

(If you read the full definition – congratulations!)

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Clearly, the metrics above are not the same.

And we should not assume that EBITDA means the same thing to everybody.

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There are at least two important situations when we have to pay special attention:

1) Loan agreements

Regardless of your role – a lender or a borrower – the definition of EBITDA has to be clear.

Before accepting any financial or non-financial covenant linked to EBITDA, it is important to fully understand the definition and whether the proposed thresholds make sense. It might be difficult (and expensive!) to change it.

2) Company analyses

In company analyses, it is important to know how the management defines the term EBITDA, because S&P’s research on EBITDA addbacks found the following:

* “…marketing EBITDA is not a realistic indication of future EBITDA and that companies consistently overestimate debt repayment.”

* “…these effects meaningfully underestimate future leverage and credit risk.”

* “Actual leverage continues to be far in excess of management projections…”

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EBITDA as a metric is here to stay.

We “just” need to learn how to deal with it.

It all starts with understanding the definition.

Only then it should be used in loan agreements and analyses.

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