![As an example, the companies in the timeshare industry
recognize revenue far in advance of cash collection. In the
early 2000s, Sunterra Corp. was the world’s largest vaca-
tion ownership company, as measured by resort locations
and owner families. Only about 10 percent of the sales price
of the vacation ownership interest is paid in cash at the time
of the sale. Sunterra historically offered customer financing,
which was collateralized by the underlying vacation own-
ership interest. On average, the company financed approxi-
mately 80 percent of its domestic vacation ownership interest
revenues. Accordingly, the company did not generate suf-
ficient cash from sales to provide the necessary capital to
pay the costs of developing additional resorts and replenish
working capital.
To finance vacation ownership sales, Sunterra histori-
cally monetized the related mortgages receivable through
the use of off-balance-sheet conduits, securitizations,
whole mortgages receivable sales and other financial vehi-
cles. Therefore, using EBITDA can be misleading because
revenues earned do not always equate to cash in the same
time frame.
Another disadvantage of using EBITDA as a metric is it
fails to consider the uncertainty involved with the collection
of accounts receivable. As shown above, most of the rev-
enues earned in the sale of a vacation ownership interest are
not paid in cash but rather are financed and recorded by the
company as mortgages receivable. Under GAAP, a company
must evaluate its outstanding accounts receivable and esti-
mate how much of the total is likely uncollectible. Estimating
the collectability of accounts receivable is difficult, and com-
panies generally base their estimate on past experience.
Using Sunterra as an example again, in the fourth quar-
ter of 1999, the company recorded a $43 million after-tax
charge related to its mortgages receivable. The company
stated in its 1999 Form 10-K that “[t]his charge is the result
of an in-depth review of our balance sheet, which we initi-
ated at year-end.” The total mortgages receivable as report-
ed on Sunterra’s 1999 balance sheet was approximately
$244 million, net of an allowance for doubtful accounts
of approximately $20.1 million. Therefore, at that time,
Sunterra estimated that only 7.6 percent of its mortgages
receivable were uncollectible.
In 2000, the year after the write-down (or after-tax
charge), the company’s 2000 balance sheet stated mortgages
receivable of approximately $188.2 million, net of an allow-
ance for doubtful accounts of approximately $37.3 million,
increasing the percentage of mortgages receivable deemed to
be uncollectible from 7.6 percent to 16.6 percent. As you can
see, management’s initial estimated allowance for doubtful
accounts in 1999 of $20.1 million was not close to the actual
write-off of $43 million. Based on management’s statement,
the company did not perform an in-depth analysis each time
reserves were estimated, as is required by GAAP. As seen
in this example, the earnings used in EBITDA include esti-
mates, which are just that: estimates.
As a side note, in May 2000, Sunterra and numerous affil-
iates filed voluntary petitions for chapter 11 relief. For sever-
al months leading up to the filing, the company experienced
severe liquidity problems that arose in part because potential
lenders were unwilling to lend against the mortgages receiv-
able. If analysts and investors were using EBITDA solely
as a measure of the company’s ability to generate cash, they
would have been in for a surprise, as EBITDA was positive.
Estimates pertaining to the collectability of accounts
receivable is just one of many variables affecting the deter-
mination of earnings and therefore affecting the calculation
of EBITDA. Revenue recognition is a cornerstone of accrual
accounting together with the matching principle. According
to GAAP, revenue is recognized when realized or realizable,
and earned (usually when goods are transferred or services
are rendered) no matter when cash is received. The afore-
mentioned example involving attorneys’ fees illustrates the
concept of revenue recognition (recognizing revenue during
the period that it is earned). Similarly, the matching principle
requires a company to match expenses with the related rev-
enues in order to report a company’s profitability during a
specified time interval. These both determine the accounting
period in which revenues and expenses are recognized.
Other revenue recognition principles that do not correlate
with the receipt of cash include “barter” transactions com-
monly used by internet companies, and “pre-need” service
revenues of death-care companies (such as funeral homes),
for which cash is placed in a trust and revenue is reported
under the percentage-of-completion accounting method,
which can similarly result in a significant gap between rev-
enues and cash.
The general takeaway is that understanding the under-
lying information that supports the EBITDA calculation is
very important. Therefore, EBITDA should not be used in
a vacuum; it is important to look at other relevant financial
and industry metrics to truly, fully understand a company’s
financial condition. abi
ABI Journal February 2017 37
EBITDA should not be used in
a vacuum; it is important to
look at other relevant financial
and industry metrics to truly,
fully understand a company’s
financial condition.
Copyright 2017
American Bankruptcy Institute.
Please contact ABI at (703) 739-0800 for reprint permission.](https://image.slidesharecdn.com/thebasicsofebitda-170202224851/85/The-Basics-of-EBITDA-2-320.jpg)
The Basics of EBITDA
- 1. Building Blocks By Blanche Zelmanovich and Coral M. Hansen E arnings before interest, taxes, depreciation and amortization (EBITDA) is a measure commonly used to evaluate a company’s profitability and the operational performance of its core operations as compared to its competitors, as it eliminates the effects of varying accounting policies, as further discussed below. EBITDA is frequently used in company valuation; the determi- nation of a purchase price and loan covenant defini- tions are often quoted as multiples of EBITDA. All of the components used to calculate EBITDA can be found on a company’s income statement. However, unlike the financial terms on a company’s income statement and other finan- cial statements, EBITDA is not a defined term under Generally Accepted Accounting Principles (GAAP), guidelines that regulate the preparation of financial statements. This means that the meth- odology of calculating EBITDA can vary from one company to another — or even within the same company from period to period. On a high level, some very basic adjustments to EBITDA can include onetime occurrences for items such as restructuring charges, which are common practice in distressed situations, to costs associated with non-recurring litigation expense. EBITDA is also commonly used by many finance professionals as an estimate of a company’s ability to generate cash. While a negative EBITDA generally indicates that a business has a profitabil- ity issue and insufficient cash flow from its core operations, a positive EBITDA does not necessarily mean that a business will generate cash. EBITDA can be a useful metric for some companies, given that it strips away non-cash reductions to earnings. For example, “fixed assets” (also known as tangi- ble assets or property, plant and equipment) is an accounting term used for assets and property that cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as “liquid assets.” The cost of purchasing a fixed asset is not recorded as a reduction to earnings (i.e., placed on the income statement) at the time of purchase. Rather, the ini- tial cost is recorded on the balance sheet and later allocated, as a depreciation expense, among peri- ods in which the asset is expected to be used. To further illustrate, if a company purchases a piece of equipment for $100,000 and it is expected to last 10 years, a depreciation expense of $10,000 per year for 10 years might be recognized, causing a reduc- tion to earnings over time rather than in one lump sum. Thus, manufacturing companies commonly have large amounts of fixed assets and significant depreciation charges, which are non-cash reductions to earnings. However, EBITDA is not synonymous with cash flow. The “E” in EBITDA represents earnings, not cash. EBITDA does not take into consideration financing costs, investment in capital expenditures, taxes and, in the cases of companies that grow through acquisition, acquisition-related cash out- lays such as the purchase of an additional business. Analysts and buyers should not ignore these types of costs, as the cash that is needed to finance these obligations is necessary if the business wishes to continue to operate and grow. Further, EBITDA ignores changes in work- ing capital, such as decreases or increases in accounts receivable balances from prior periods, which would indicate faster or slower conversion of receivables to cash. Using the aforementioned example, once the attorney finishes their case in December, revenue is recorded on the income statement and the amount owed by the client is recorded as accounts receivable on the balance sheet. Once the attorney collects the cash, their client’s account receivable is reduced or removed. Therefore, when the revenue was recorded in December, EBITDA increased even though no cash was received. When the client pays the bal- ance due in a subsequent month, EBITDA is not impacted, as EBITDA is calculated from the com- pany’s income statement. As such, there are many pitfalls that can come about by using EBITDA as a proxy for cash from operations. At a basic level, earnings in EBITDA are rev- enues less expenses. Revenue recognition varies across industries and does not always equate to cash within the same time frame. For example, an attorney may finish a huge case in December, but may not collect the revenue earned for those ser- vices until the following year. Those who work in the professional services industry are all too aware of this, which is a reason why most tax returns are prepared using the cash method vs. the accrual method of accounting. Under the accrual method of accounting, the revenue earned in December will increase December’s net income (earnings) and its accounts receivable but will not increase, or change at all, December’s cash flow, and therefore may not be available to pay the current year’s income taxes, as the collection of revenue would not likely occur until the following calendar year. Coral M. Hansen CBIZ Corporate Recovery Services Los Angeles The Basics of EBITDA 36 February 2017 ABI Journal Blanche Zelmanovich, CIRA is a managing director of CBIZ’s Corporate Recovery Services Practice in New York. Coral Hansen, CPA, ABV, CFE, CFF is a managing director in the firm’s Los Angeles office. Blanche Zelmanovich CBIZ Corporate Recovery Services New York
- 2. As an example, the companies in the timeshare industry recognize revenue far in advance of cash collection. In the early 2000s, Sunterra Corp. was the world’s largest vaca- tion ownership company, as measured by resort locations and owner families. Only about 10 percent of the sales price of the vacation ownership interest is paid in cash at the time of the sale. Sunterra historically offered customer financing, which was collateralized by the underlying vacation own- ership interest. On average, the company financed approxi- mately 80 percent of its domestic vacation ownership interest revenues. Accordingly, the company did not generate suf- ficient cash from sales to provide the necessary capital to pay the costs of developing additional resorts and replenish working capital. To finance vacation ownership sales, Sunterra histori- cally monetized the related mortgages receivable through the use of off-balance-sheet conduits, securitizations, whole mortgages receivable sales and other financial vehi- cles. Therefore, using EBITDA can be misleading because revenues earned do not always equate to cash in the same time frame. Another disadvantage of using EBITDA as a metric is it fails to consider the uncertainty involved with the collection of accounts receivable. As shown above, most of the rev- enues earned in the sale of a vacation ownership interest are not paid in cash but rather are financed and recorded by the company as mortgages receivable. Under GAAP, a company must evaluate its outstanding accounts receivable and esti- mate how much of the total is likely uncollectible. Estimating the collectability of accounts receivable is difficult, and com- panies generally base their estimate on past experience. Using Sunterra as an example again, in the fourth quar- ter of 1999, the company recorded a $43 million after-tax charge related to its mortgages receivable. The company stated in its 1999 Form 10-K that “[t]his charge is the result of an in-depth review of our balance sheet, which we initi- ated at year-end.” The total mortgages receivable as report- ed on Sunterra’s 1999 balance sheet was approximately $244 million, net of an allowance for doubtful accounts of approximately $20.1 million. Therefore, at that time, Sunterra estimated that only 7.6 percent of its mortgages receivable were uncollectible. In 2000, the year after the write-down (or after-tax charge), the company’s 2000 balance sheet stated mortgages receivable of approximately $188.2 million, net of an allow- ance for doubtful accounts of approximately $37.3 million, increasing the percentage of mortgages receivable deemed to be uncollectible from 7.6 percent to 16.6 percent. As you can see, management’s initial estimated allowance for doubtful accounts in 1999 of $20.1 million was not close to the actual write-off of $43 million. Based on management’s statement, the company did not perform an in-depth analysis each time reserves were estimated, as is required by GAAP. As seen in this example, the earnings used in EBITDA include esti- mates, which are just that: estimates. As a side note, in May 2000, Sunterra and numerous affil- iates filed voluntary petitions for chapter 11 relief. For sever- al months leading up to the filing, the company experienced severe liquidity problems that arose in part because potential lenders were unwilling to lend against the mortgages receiv- able. If analysts and investors were using EBITDA solely as a measure of the company’s ability to generate cash, they would have been in for a surprise, as EBITDA was positive. Estimates pertaining to the collectability of accounts receivable is just one of many variables affecting the deter- mination of earnings and therefore affecting the calculation of EBITDA. Revenue recognition is a cornerstone of accrual accounting together with the matching principle. According to GAAP, revenue is recognized when realized or realizable, and earned (usually when goods are transferred or services are rendered) no matter when cash is received. The afore- mentioned example involving attorneys’ fees illustrates the concept of revenue recognition (recognizing revenue during the period that it is earned). Similarly, the matching principle requires a company to match expenses with the related rev- enues in order to report a company’s profitability during a specified time interval. These both determine the accounting period in which revenues and expenses are recognized. Other revenue recognition principles that do not correlate with the receipt of cash include “barter” transactions com- monly used by internet companies, and “pre-need” service revenues of death-care companies (such as funeral homes), for which cash is placed in a trust and revenue is reported under the percentage-of-completion accounting method, which can similarly result in a significant gap between rev- enues and cash. The general takeaway is that understanding the under- lying information that supports the EBITDA calculation is very important. Therefore, EBITDA should not be used in a vacuum; it is important to look at other relevant financial and industry metrics to truly, fully understand a company’s financial condition. abi ABI Journal February 2017 37 EBITDA should not be used in a vacuum; it is important to look at other relevant financial and industry metrics to truly, fully understand a company’s financial condition. Copyright 2017 American Bankruptcy Institute. Please contact ABI at (703) 739-0800 for reprint permission.