The Finance Gem 💎 Week #66: CEO Failures and EBITDA Abuses

THIS WEEK’S ISSUE AT A GLANCE

This week’s finance Gems 💎 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 WEEK’S FINANCE GEMS

1. Why CEOs Fail

70% of all Company Initiatives Fail.

Here’s how CEOs can Beat the Odds.

There are 5 main root causes for every organizational failure.

↳ Lacking Vision

↳ Lacking Skills

↳ Lacking Incentives

↳ Lacking Resources

↳ Lacking Action Plan

Here’s what each of these common leadership challenges means and how they impact:

↳ Lack of Clear Vision

↳ failure to articulate a compelling future for the organization

↳ leads to confusion and misalignment within the organization, resulting in ineffective decision-making

↳ Inadequate Skills or Adaptability

↳ failure to secure or deploy the necessary leadership or industry-specific skills

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

↳ Misaligned Incentives

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

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

↳ Insufficient Resources

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

↳ leads to limited ability to implement strategies effectively, innovate, or respond to market demands

↳ Lack of an Action Plan

↳ failure to develop or execute an effective action plan to achieve strategic objectives

↳ leads to wasted resources, missed opportunities, and inability to capitalize on market potential

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2. 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

1️⃣ Provisions

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

The traditional view is that these aren’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

2️⃣ Non-operating income

⚫ This is usually passive income which isn’t related to the company’s core operations.

Most parties will agree that if the company isn’t actively in the business of generating that income, it shouldn’t be part of the company’s EBITDA.

3️⃣ Unrealized gains or losses

⚫ 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 don’t belong in EBITDA.

4️⃣ One-time revenue or expenses

⚫ These are the result of non-recurring transactions.

The typical view is that because they aren’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.

5️⃣ Foreign exchanges gains or losses

⚫ These are the result of incidental transactions outside the company’s core operations.

If the company isn’t an FX boutique or exchange, FX gains and losses typically aren’t part of the company’s EBITDA. This becomes a contentious topic when FX gains are claimed to be the result of purposely crafted and implemented FX hedging strategies

6️⃣ Goodwill impairment

⚫ 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 “paper loss” that doesn’t belong in EBITDA.

7️⃣ Asset write-downs

⚫ 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 they’re non-cash, they don’t belong in EBITDA.

8️⃣ Litigation or insurance expenses outside the regular course of business.

⚫ 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 aren’t repeatable, they don’t belong in EBITDA.

9️⃣ Owner compensation over/under market value

⚫ In private companies, owners often don’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 owner’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 company’s Debt Service Ratio and/or leverage capacity.

🔟Share-based compensation

⚫ “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?” (Warren Buffett)

Some will argue that share-based compensation isn’t actual cash outflows while others will maintain that they are real expenses incurred to attract and retain executive level talent.

3. 5 EBITDA Alternatives to Know

Are you trying to evaluate a company’s financial performance?

Don’t use EBITDA.

Here’s why:

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

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

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

☑️ includes working capital investment

☑️ includes long term capital investment

☑️ includes payment obligations on debt

☑️ 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

⚫Possible Adjustments List:

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

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

>> rental expenses (banks)

>> proforma “what-if” expenses or cost savings (M&A)

>> CAPEX

>> cash taxes

>> distributions (banks)

>> working capital investments

>> fixed capital investments

✅Pros: easily calculated

❌Cons: most adjustments won't include debt payments, CAPEX or working capital investments

🎯How 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. 𝗢𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄(𝗢𝗖𝗙)

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

✅Pros: includes tax payment obligations and working capital investment

❌Cons: doesn’t include long term capital investment or payments on debt obligations

🎯How 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. 𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 𝘁𝗼 𝘁𝗵𝗲 𝗙𝗶𝗿𝗺 (𝗙𝗖𝗙𝗙 𝗼𝗿 𝗨𝗻𝗹𝗲𝘃𝗲𝗿𝗲𝗱 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄)

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

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

❌Cons: doesn’t include debt payment obligations

🎯How 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. 𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 𝘁𝗼 𝗘𝗾𝘂𝗶𝘁𝘆 𝗛𝗼𝗹𝗱𝗲𝗿𝘀 (𝗙𝗖𝗙𝗘 𝗼𝗿 𝗟𝗲𝘃𝗲𝗿𝗲𝗱 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄)

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

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

❌Cons: could be complex to calculate and information may not be readily available

🎯How 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)

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

❌Cons: could be complex to calculate.

🎯How to use: 

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

>> Performance management: set performance targets based on EVA

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