By Robin Currie
The Currie Financial Model employs several critical liquidity and profitability measures for participating distribution clients. This collection of calculations makes up what we call “the Report Card for the Executive.” Included in this report are debt to equity ratio, absorption, current ratio, asset turns, return on assets, etc. What is conspicuously not included in the Currie Financial Composite is any EBITDA computation.
Many dealer clients have asked us why we never report a client’s EBITDA result on the report card. The short answer is that we prefer to measure Return On Assets (ROA). ROA tells us how effective an enterprise is at utilizing its assets to create profitability. ROA also reflects all other measures that are critical to dealership operational success. A high ROA indicates solid operational performance. ROA also lets us know the investment return of a dealership before any leverage impact.
EBITDA, which is Earnings Before Interest, Taxes, Depreciation and Amortization, measures a company’s financial performance. Often it is referred to as a proxy for cash flow. In fact, for it to be a proxy for cash flow, the proper measure is EBITDA – Capital Expenditures (CapEx). So EBITDA without any reference to “CapEx” is an incomplete cash flow measure. Further, why use a cash flow proxy when actual cash flow statements already show real cash flow? So, if you want a Cash Flow Return On Investment (CFROI), use actual cash flow divided by your investment base.
Let’s mention here Warren Buffet’s remarks during the 2002 Berkshire Hathaway Annual Meeting: “People who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs.” Mr. Buffett, a well-known investment guru, has also commented that companies that insist upon using the EBITDA method are suspect and can even be considered to have fraudulent reporting practices.
Let’s go back and discuss further the points in favor of measuring ROA in the place of EBITDA. ROA is measured as Net Profit % X Asset Turns and, as stated earlier, the result summarizes all other financial measures in a company. Benchmark ROA for an industrial equipment distributor is 15 percent. The numbers that comprise that 15 percent are Net Profit Before Tax of 5 percent (according to the Currie Financial Model) and Asset turns of 3X. An organization can increase its ROA by improving its net profit. Another way to boost ROA is to increase revenues, thus more efficiently leveraging the company’s assets. As an investor, it’s easy to examine the two individual measures that make up the ROA calculation, thus determining more precisely the performance of the company. Further, empirical data shows that an ROA of 9 percent is roughly cash neutral. So, an ROA of 15 percent is 6 percent in positive cash and an ROA of 6 percent is 3 percent into negative cash. Our 15 percent ROA goal is designed to always produce positive cash.
Remember, when using ROA as a comparative result, comparing it to your organization’s previous results or to results of similar industries is best. This is due to the fact that benchmarks for the ROA measure vary depending upon the industry and the level of capital intensity associated with that particular industry.
In summary, those seeking to acquire or to analyze a business should not rely on EBITDA to measure the performance of a business. To the extent EBITDA is used, acquirers should replace the removed interest, taxes, depreciation and amortization from their earnings calculations with their own expected operating numbers to get a better picture of anticipated profitability and cash flow and the variability to the cash flow. Instead, the measures listed in the opening paragraph of this article, such as ROA, liquidity ratios and the like, are much more precise and provide us with better performance metrics that EBITDA. In other words, let’s craft the report card using the most beneficial reporting measurements.
Robin Currie is with Currie Management Consultants, Inc., located in Worcester, Massachusetts, and on the web at www.curriemanagement.com.