The front page of the Financial Times is not normally a bundle of fun but I couldn’t help but burst out laughing at the piece on 14th May entitled “Analysts sceptical as ‘earnings before coronavirus’ flatter company books”. It relates that Schenck Process, a German manufacturing group, added back €5.4m of first-quarter profits that it said it would have made were it not for the hit caused by lockdown. Its operating profit for the period — “adjusted EBITDAC” of €18.3m — was almost 20 per cent higher than the same period a year earlier, rather than 16 per cent lower.
Adjusted EBITDAC??? Earnings before interest, tax, depreciation, amortisation and Coronavirus. Really???
As if EBITDA weren’t bad enough. This much abused metric has become a proxy for cashflow, which it absolutely isn’t. It has become the basis of inter-company comparisons which are absolutely spurious, as if interest payments and notional costs for the use of a company’s assets do not matter, as if taxation does not matter. The cashflow a company has at its disposal is subject to all these things. Depreciation and amortisation of a company’s assets may be ‘non cash items’ in an accounting context but capex and investments into a company’s assets certainly are cash items, which the focus on EBITDA completely ignores. The same goes for the working capital requirement.
Despite coming into the lexicon early in my investment career, EBITDA has never appeared on any of my spreadsheets. That is not to say I never look at it. At times one is compelled to for the simple reason that companies talk of little else when discussing margins and gearing. So to forecast operating margin or EBIT margin you have to work out what D & A is likely to be as a percentage of sales and adjust because companies normally guide on EBITDA margin development, not EBIT. Likewise, when it comes to gearing, Net Debt to EBITDA, is frequently the basis of banking covenants. But why? Shouldn’t capex and working capital requirements count in a bank’s assessment of the credit worthiness of a debtor company?
Only by looking at cashflow after tax, (as is often said, nothing in life is as certain as death and taxes!) and its sufficiency to cover the working capital requirement, capex and investments, and hopefully pay a dividend too, does one have any real idea of the profitability of a business.
So where does that leave EBITDAC? In the bin for us. It is derisory. We do not know what is going to happen tomorrow. We cannot tell what might have been. Yes, some revenues will have been deferred by Covid-19. If you don’t buy a house this year you might next year, assuming you haven’t lost your job, but some revenues will just have been completely lost. You are not going to buy two new handbags next summer because you didn’t buy one this summer. You will buy one at best and maybe you will decide to use last year’s for another year and buy none.
So my reaction to the FT article was really of the kind reserved for a Friday afternoon after a heavy week in the office, when the slightest nonsense sends you off into a fit of uncontrollable laughter, mainly as a safety valve to stop you exploding.
We have had to contend with the nonsense of EBITDA so long, and now EBITDAC.
I should add that after 30 years analysing company accounts and persuading my junior colleagues of the importance of cashflow and cashflow statements I have come to the sad conclusion that they mostly aren’t worth the paper they are written on. They are not ‘audited’ in the traditional sense i.e. checked or verified in the way anyone might reasonably expect. Our strong impression is that the accounting firms are mostly just rubber stamping what managements tell them about cashflows in and out, and collecting nice fees deducted against shareholder returns for their efforts. Except, that is, during the current crisis, when they are trying to cover their backs by refusing to provide unqualified opinions on companies as going concerns unless they have sufficient cash in the bank to cover 6 to 12 months of outgoings with no revenues at all, and thereby forcing dilutive capital raisings on shareholders. Then they might actually check the cash position.
So where does this leave investment managers trying to do their due diligence? Laughing uncontrollably on a Friday afternoon.
In the end it boils down to knowing your managements and using your best judgment that the companies to whom you are entrusting your clients’ money are run ethically. Financial statements may give you a broad brush, but you cannot rely on them wholly. Looking at how a company treats its clients, employees and shareholders in practice is an essential part of investment analysis today.
Back to our ESG audit…
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