EBITDA
Dangers of Optimistic Numbers
It's the morning after the party that the headache starts. Only when the tide goes out does one know who is swimming naked. These are lines and quotes often cited to warn against indulgence – especially in the financial markets.
In the days of zero or soft interest rates and sloshing liquidity, many "pie in the sky" projects secured loans and acquisitions were funded by giving a go-by to some prudent accounting norms.
Now, as central banks worldwide, including the Reserve Bank of India, are tightening liquidity and raising interest rates, the days of the 'devil may care' attitude days are over, and investors have woken up to smell the coffee.
Usually, loans are raised through the issue of bonds or debt securities by showing creditors the strength of 'EBITDA', or Earnings Before Interest, Tax, Depreciation and Amortisation. This parameter gauges a company's ability to generate cash flow and repay debt.
But excessive reliance led to the practice of adding back various line items to earnings projections, which some viewed as unrealistic and exaggerated.
Just not cricket
When some of the bankers and private equity firms tried to sell some of the loans that funded some merger and acquisition transactions, they added items that were not part of operations to project a higher EBITDA.
So, what were the items that got added to inflate EBITDA?
Non-operating items from the profit & loss statement, like management fees, restructuring gains and synergy benefits, were considered, in many cases, to project an inflated operating cash flow or EBITDA.
A recent report by S&P Global Ratings said many of these cashflow projections were way off the mark. In some M&A deals in 2019 and 2020, that were funded by debt, the reported EBITDA was down 36-39% compared with the projections.
Prudent practices require that synergy benefits restructuring costs and management fees are not added back while calculating cash flow in M&A deals.
Interestingly, the research points out, 97% of companies that announced acquisitions in 2019 and indulged in a bit of 'add back' to EBITDA missed their earnings forecasts, while the figures were 96% for 2018 deals and 93% for 2017 acquisitions.
S&P ratings reminded me of the perils of "buying in" to overly optimistic management forecasts. The credit rating agency noted that their ratings are based on internal estimates of a company's expected earnings, capacity and appetite for debt repayment and a considered view of issues like management projected synergies or cost efficiencies.
The recent report by S&P serves as a reminder that prudence is at the center of investing and that investors must 'not chase returns at all costs'.
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