Like HowStuffWorks on Facebook!

What is EBITDA?

The Problems with EBITDA

One of the main problems with EBITDA is that some companies try to use it as a substitute for cash flow [source: McCaffrey]. Cash flow not only indicates how much a company earned and how much it spent, but when the cash actually changed hands. This is an important distinction because earnings and cash earnings aren't the same thing. If a company spends cash to make a product, but the product sits in a warehouse for a year before a consumer actually pays for it, then the company may not have enough cash on hand to pay its creditors and run its daily operations. This could lead to further debt and even bankruptcy.

On the surface, EBITDA looks a lot like cash flow because it focuses exclusively on money earned from the daily operation of the business. But the truth is that earnings and cash flow are calculated using two completely different accounting methods. Accrual accounting counts a sale as soon as the product ships to the retailer. Cash accounting counts a sale only when the retailer pays for the order in full. Since EBITDA is based on accrual accounting figures, it doesn't accurately represent cash that the company has collected -- just what it has earned on paper [source: Wayman].

Another reason that EBITDA is a bad indicator of cash earnings is because the real cash flow of a company is directly affected by two of the things that EBITDA ignores: interest and taxes [source: Weiss]. Companies must pay interest and they must pay taxes (before they can even pay dividends to investors) and that cash has to come from somewhere.

EBITDA also ignores depreciation and amortization, two accounting methods used to spread out the expense of large capital investments. For a young company, these capital investments can be considerable; critics of EBITDA say that ignoring the long-term financial impact of such investments is dangerous [source: McClure].

But at the end of the day, many analysts and investors have soured on EBITDA simply because the numbers are so easy to fudge [source: Smith]. Unfortunately, EBITDA has been used by too many dangerously leveraged companies -- including those infamous dotcom flameouts -- to skirt GAAP standards and fool unsuspecting investors, earning it a bad reputation on Wall Street.

Keep reading for lots more investment info and advice.

More to Explore