E-B-I-T-D-A It Doesn’t Spell “Cash Flow”
“We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group” -Warren Buffett
Investors should be cautious with the companies that use non-standard metrics to report their earnings. EBITDA (earnings before interest, taxes, depreciation, and amortization) is often used as a proxy for cash flows, but it isn’t. One should not rely on EBITDA as a true measure of the cash the company has earned in a given year. Since accrual accounting depends on management’s judgement and estimates, the income statement is very sensitive to earnings manipulation and shenanigans. One way to analyse such companies is to study the relationship between the CFO (cash flow from operations) and EBITDA. A CFO to EBITDA ratio of significantly less than 1 for an extended period can mean that the company is not able to translate its profits on books into cash profits.
One such example is Kraft Heinz Co. (KHC). The company’s tailored financial metric of adjusted EBITDA makes its results look better.
The large gap between the adjusted operating earnings and cash flow from operations of Kraft Heinz is due to the exclusion of integration and restructuring expenses, equity compensation, and interest payments to calculate adjusted EBITDA. These expenses can’t be stripped out to calculate the operating cash flow. So even though the company only earned $0.5 billion cash in the year 2017, its adjusted EBITDA is $7.664 billion (15 times higher than the CFO). The CFO/EBITDA ratio for Kraft Heinz has been constantly below 1 as shown below :
Hence we can conclude that Kraft Heinz has not been able to convert all of its book profits into cash profits, making the adjusted EBITDA an unreliable cash profit metric. Charlie Munger rightly calls EBITDA as ‘bullshit’ earnings.