The Finance Gem ๐Ÿ’Ž Week #66: CEO Failures and EBITDA Abuses

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WELCOME TO ISSUE NO #66

THIS WEEKโ€™S ISSUE AT A GLANCE

This weekโ€™s finance Gems ๐Ÿ’Ž vote your favorite in the poll section

  • Why CEOs Fail

  • Adjusted EBITDA is Still Not Cash Flow

  • 5 EBITDA Alternatives to Know

Joke of the week:

Why did the CEO bring EBITDA to the gym?

Because they heard it's great at pumping up the numbers!

  1. The EBITDA vs. Cash Flow poll on Linkedin closed. See result below and tell me how you voted/would have voted.

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THIS WEEKโ€™S FINANCE GEMS

  1. Why CEOs Fail

70% of all Company Initiatives Fail.

Hereโ€™s how CEOs can Beat the Odds.

There are 5 main root causes for every organizational failure.

โ†ณ Lacking Vision

โ†ณ Lacking Skills

โ†ณ Lacking Incentives

โ†ณ Lacking Resources

โ†ณ Lacking Action Plan

Hereโ€™s what each of these common leadership challenges means and how they impact:

โ†ณ Lack of Clear Vision

โ†ณ failure to articulate a compelling future for the organization

โ†ณ leads to confusion and misalignment within the organization, resulting in ineffective decision-making

โ†ณ Inadequate Skills or Adaptability

โ†ณ failure to secure or deploy the necessary leadership or industry-specific skills

โ†ณ leads to poor management, inability to inspire or lead the team effectively, and falling behind competitors.

โ†ณ Misaligned Incentives

โ†ณ failure to create incentive structures that align with long-term company goals, and motivate and retain top talent

โ†ณ leads to misdirected efforts, prioritizing short-term gains over sustainable growth, and high turnover of key staff.

โ†ณ Insufficient Resources

โ†ณ failure to secure sufficient resources or mismanaging the resources available (human, financial, and technological)

โ†ณ leads to limited ability to implement strategies effectively, innovate, or respond to market demands

โ†ณ Lack of an Action Plan

โ†ณ failure to develop or execute an effective action plan to achieve strategic objectives

โ†ณ leads to wasted resources, missed opportunities, and inability to capitalize on market potential

POLL TIME

Which of these 5 failures have you seen most frequently?

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  1. Adjusted EBITDA is Still Not Cash Flow

Adjusted EBITDA is Still Not Cash Flow.

Here are 10 sneaky EBITDA Adjustments to be aware of. Depending on the side you're playing for, you may find yourself arguing pro or against these

1๏ธโƒฃ Provisions

โšซ Guarantees. Future tax obligations. Asset Retirement Obligations. Asset impairment. Losses. Pensions. Severance costs.

The traditional view is that these arenโ€™t actual obligations and should be added back to EBITDA, especially when a lot of management assumptions which could later be provide incorrect are involved in determining the provisioned amounts. Others however believe that provisions represent real anticipated expenses and should not be added back to EBITDA to avoid inflating the operating performance of the company

2๏ธโƒฃ Non-operating income

โšซ This is usually passive income which isnโ€™t related to the companyโ€™s core operations.

Most parties will agree that if the company isnโ€™t actively in the business of generating that income, it shouldnโ€™t be part of the companyโ€™s EBITDA.

3๏ธโƒฃ Unrealized gains or losses

โšซ These are increases or decreases in the value of an asset or a liability that has not yet been sold or settled.

The typical view is that paper gains and losses donโ€™t belong in EBITDA.

4๏ธโƒฃ One-time revenue or expenses

โšซ These are the result of non-recurring transactions.

The typical view is that because they arenโ€™t repeatable they do not belong in EBITDA. However, others may seek evidence to prove the contrary and support that what appears to be a one-time event will actually repeat in future periods.

5๏ธโƒฃ Foreign exchanges gains or losses

โšซ These are the result of incidental transactions outside the companyโ€™s core operations.

If the company isnโ€™t an FX boutique or exchange, FX gains and losses typically arenโ€™t part of the companyโ€™s EBITDA. This becomes a contentious topic when FX gains are claimed to be the result of purposely crafted and implemented FX hedging strategies

6๏ธโƒฃ Goodwill impairment

โšซ This is a decrease in the value of goodwill reported following an acquisition.

While this indicates concerns regarding the original price paid in the acquisition, it is still typically considered a โ€œpaper lossโ€ that doesnโ€™t belong in EBITDA.

7๏ธโƒฃ Asset write-downs

โšซ These are decreases in the value of an asset, usually following non-recurring events like sharp technological advancements that rendered a machine obsolete ahead of its time.

The usual consensus is that because theyโ€™re non-cash, they donโ€™t belong in EBITDA.

8๏ธโƒฃ Litigation or insurance expenses outside the regular course of business.

โšซ These are the result of non-recurring transactions such as one-time lawsuits, large financing deals or outlier commercial contracts.

Most will argue that if they arenโ€™t repeatable, they donโ€™t belong in EBITDA.

9๏ธโƒฃ Owner compensation over/under market value

โšซ In private companies, owners often donโ€™t pay themselves a fair salary, or they pay themselves more than a comparable executive role would pay an employee.

A buyer will usually adjust the ownerโ€™s salary to level up to the market and will impact EBITDA upwards or downwards in the process. Similarly, a lender might employ the same approach to determine a maintainable level of EBITDA in support of calculating a companyโ€™s Debt Service Ratio and/or leverage capacity.

๐Ÿ”ŸShare-based compensation

โšซ โ€œIf options arenโ€™t a form of compensation, what are they? If compensation isnโ€™t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?โ€ (Warren Buffett)

Some will argue that share-based compensation isnโ€™t actual cash outflows while others will maintain that they are real expenses incurred to attract and retain executive level talent.

Which EBITDA Adjustment do you encounter most often?

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  1. 5 EBITDA Alternatives to Know

Are you trying to evaluate a companyโ€™s financial performance?

Donโ€™t use EBITDA.

Hereโ€™s why:

๐ŸŽฏ EBITDA is flawed and unfit for most of the roles it has today.

๐ŸŽฏ EBITDA frequently gets adjusted to suit users individual needs and help mitigate their risks.

๐ŸŽฏ EBITDA needs replacing with a better profitability/cash flow measure that:

โ˜‘๏ธ includes working capital investment

โ˜‘๏ธ includes long term capital investment

โ˜‘๏ธ includes payment obligations on debt

โ˜‘๏ธ includes tax payment obligations

Here are 5 alternatives to EBITDA you can consider, depending on your business objectives:

1. Adjusted EBITDA to resemble cash

= Net Income + Interest + Taxes + Depreciation + Amortization + Adjustments

โšซPossible Adjustments List:

>> non-recurring expenses (management/M&A)

>> normalized depreciation/amortization (management, M&A)

>> rental expenses (banks)

>> proforma โ€œwhat-ifโ€ expenses or cost savings (M&A)

>> CAPEX

>> cash taxes

>> distributions (banks)

>> working capital investments

>> fixed capital investments

โœ…Pros: easily calculated

โŒCons: most adjustments won't include debt payments, CAPEX or working capital investments

๐ŸŽฏHow to use (adjusted to a measure to free cash flow):

>> Valuation: estimate future company cash flows and terminal value calculate enterprise value

>> Debt Servicing: estimate annual debt servicing capacity (principal + interest)

2. ๐—ข๐—ฝ๐—ฒ๐—ฟ๐—ฎ๐˜๐—ถ๐—ป๐—ด ๐—–๐—ฎ๐˜€๐—ต ๐—™๐—น๐—ผ๐˜„(๐—ข๐—–๐—™)

= Net Income + Depreciation/Amortization + Other Non Cash Items +/ Changes in Working Capital

โœ…Pros: includes tax payment obligations and working capital investment

โŒCons: doesnโ€™t include long term capital investment or payments on debt obligations

๐ŸŽฏHow to use:

>> Financial Health: calculate the amount of cash generated by core operations to pay for fixed asset maintenance/investments, debt servicing costs, and shareholder distributions

3. ๐—™๐—ฟ๐—ฒ๐—ฒ ๐—–๐—ฎ๐˜€๐—ต ๐—™๐—น๐—ผ๐˜„ ๐˜๐—ผ ๐˜๐—ต๐—ฒ ๐—™๐—ถ๐—ฟ๐—บ (๐—™๐—–๐—™๐—™ ๐—ผ๐—ฟ ๐—จ๐—ป๐—น๐—ฒ๐˜ƒ๐—ฒ๐—ฟ๐—ฒ๐—ฑ ๐—–๐—ฎ๐˜€๐—ต ๐—™๐—น๐—ผ๐˜„)

= Operating Cash Flow + Interest x (1- Tax Rate) +/- Changes in Fixed Assets

โœ…Pros: includes tax payment obligations, working capital investment, and long term capital investment

โŒCons: doesnโ€™t include debt payment obligations

๐ŸŽฏHow to use:

>> Valuation: estimate the value of the company (debt + equity) as the present value of future Free Cash Flows to the Firm (FCFF) discounted at the weighted average cost of capital (WACC)

4. ๐—™๐—ฟ๐—ฒ๐—ฒ ๐—–๐—ฎ๐˜€๐—ต ๐—™๐—น๐—ผ๐˜„ ๐˜๐—ผ ๐—˜๐—พ๐˜‚๐—ถ๐˜๐˜† ๐—›๐—ผ๐—น๐—ฑ๐—ฒ๐—ฟ๐˜€ (๐—™๐—–๐—™๐—˜ ๐—ผ๐—ฟ ๐—Ÿ๐—ฒ๐˜ƒ๐—ฒ๐—ฟ๐—ฒ๐—ฑ ๐—–๐—ฎ๐˜€๐—ต ๐—™๐—น๐—ผ๐˜„)

= Operating Cash Flow +/- Changes in Fixed Assets +/- Changes in Net Debt

โœ…Pros: includes working capital investment, tax payment obligations, long term capital investment, and payment of debt obligations

โŒCons: could be complex to calculate and information may not be readily available

๐ŸŽฏHow to use:

>> Valuation: estimate the value of the company equity as the present value of future Cash Flows to Equity (FCFE) discounted at the required rate of return on equity

>> Business decision making:

- how much capital to distribute to shareholders?

- how much capital to retain in the business to support growing working capital needs from growing sales?

- how much debt can the business actually service?

- how much capital can be used to invest in M&A activity

5. Economic Value Added

= EBIT - Tax on EBIT- WACC x (Fixed Assets + Net Working Capital)

โœ…Pros: includes tax payment obligations as well as a cost of capital charge for working capital investment, long term capital investment, and outstanding debt.

โŒCons: could be complex to calculate.

๐ŸŽฏHow to use: 

>> Valuation: estimate the value of the company by adding the current capital invested in the companyโ€™s assets to the present value of current and future EVA.

>> Performance management: set performance targets based on EVA

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