Credit can be a good determinant of cash flows
EBITDA can be a good determinant of cash flows and it is the most commonly used measure for a company’s credit quality, for example, by computing coverage and leverage ratios. However, the use of EBITDA as a single measure of cash flows can be misleading, hence other factors have to be considered. The following are some critical points:
EBITDA ignores changes in working capital and overstates cash flows in periods of working capital growth.
EBITDAsays nothing about the quality of earnings and can be a misleading measure of a company’s liquidity.
EBITDA can be manipulated through aggressive accounting policies relating to revenue and expense recognition, asset write-downs, excessive adjustments in deriving “adjusted pro-forma EBITDA” and by timing asset sales.
EBITDA does not take into consideration the many unique attributes of different industries.
If some start-up companies (e.g. most of the noninvestment gradeEuropean telecommunications companies) have negative EBITDA, the computation of current financial ratios becomes almost meaningless and one has to focus on the growth trend, for example, whether the EBITDA loss narrows or widens over time. When computing the leverage ratio for these companies EBITDA can be replaced by PP&E (Property, Plant and Equipment). The ratio (Total Debt/PP&E) is a limited measure for leverage, hence debt protection.
