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Insights on business -- and life.

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A hypothetical example of how it's determined and what it does and doesn't mean.

by Mike Dolan (December 1, 2008)

Let's say that there is a retailer headed by Mr. X, who hires you as the Chief Operating Officer and me as the Chief Financial Officer. Since we are now executive managers, we get an annual bonus based upon our respective results. Your job is to buy and sell inventory, hire and maintain a retail staff and distribution centers, expand the number of stores, and improve productivity in these areas. My job is to do the books, file the tax return, borrow money when needed, and pay the bills. We all agree that total real earnings, or losses as the case may be, is the starting point for your bonus. However, there are charges and expenses included in total earnings that are not in your control.


It is my job as Chief Financial Officer to borrow money, and I try my best to do a good job. In fact, I had this great idea to borrow about $5.9 billion so that I could buy back almost all of the stock of the company. Mr. X agreed and so now we have lots of debt, and no equity. This decision was not your problem, since it had nothing to do with your operations, so you do not have to worry about it because interest on the loan is not going to be used in calculating your bonus. (My borrowing strategy is discussed later.)


The main reason I got my job is because I am a tax wizard. I know of every loophole, tax break, and strategy that there is. For example, when Mr. X hired me he wanted to move the company back east, but I told him that was not a good idea because here in Texas, there is no state income tax, and keeping it here would save a lot of money. Reluctantly, Mr. X agreed, so we are headquartered in the Lone Star State. Your bonus is not going to include income taxes because it has nothing to do with your operations.

Depreciation and Amortization.

Depreciation and amortization are not "hard" expenses because there is no cash involved. They represent the fact that you or your predecessors bought some buildings, sales racks, and other nice fixed assets used to sell your inventory, and I get to write them off for the purpose of taxes and reporting audited financial results. As with interest and taxes, you have no control over how much this will be each year. However, you will be given a firm budget on how much cash you can use every year to open new stores.

Your Bonus.

Given the above, your bonus is based on Earnings minus (before) Interest, Taxes, Depreciation and Amortization, or EBITDA. This is going to measure how much cash your operations generate each year. Said differently, this is he cash generated by the core operations. From the cash that you generate, you will get some of it back to open new stores and to expand inventory as needed. Of course, your bonus will be tied to how much better your results are from the EBITDA of prior years, so if there is improvement, you get your bonus.

You, of course, have done a fantastic job. So fantastic, that Mr. X wants to share the results with the rest of the world. Mr. X schedules a press conference and the main topic is how well you have done. He has charts and graphs that show that the EBITDA is growing at a compounded annual growth rate (CAGR) of 5% over the last five years. Since you are kind of shy, he makes me, the Chief Financial Officer, discuss the results. I also talk a little about how much cash we have and how much I can borrow in the future if I need to. This makes the banks happy because they can see I have enough to make payments in the near future.


When Mr. X bought the company, he agreed to buy all of the outstanding shares that were publicly traded for about $6 billion, and he would become the Chairman of the Board. I found a few banks that were willing to loan me almost all of the money needed to buy the stock at what some might say are sub-prime interest rates. Nevertheless, I did as I was told and repurchased all of the stock and obtained the loans, or financing, to do so. This type of deal is called a highly leveraged acquisition because Mr. X doesn't have much invested in the company.

Like most lenders, the banks looked at the ability of the company to repay them. All of the loans I found are interest only with a balloon payment at the end. Some of these loans have our entire inventory as collateral. I even found a bank that gave me a line of credit that I can use to borrow in the future if I need to. What I told the banks was that I thought we had enough cash generated from the core operations to make the interest payments. I also obtained a line of credit in case core earnings are not good. Mr. X and the banks agreed that when it came time to make the balloon payment, we would either refinance the borrowings, or take the company public again and use the cash from the stock sale to pay them.

The banks wanted to make sure we were generating enough cash, so they looked at our historical EBITDA to make sure that there was sufficient cash from our core operations to make the interest payments. We also told them that we had hired an expert (you) who will grow our EBITDA in the future.

At the most recent press conference, I reported that we had $100 million of cash in the bank, and that we can borrow another $400 million if we need to. We also talk a very little bit about our real earnings, or loss of $100 million a year, but the banks see that we can make payments for another five years or so because we have access to $500 million (the $100 million in the bank plus the $400 we can borrow) and we are losing $100 million per year.

Real Earnings and the Game Plan.

As discussed above, the real earnings of the company are a loss of $100 million per year. Because of the large amount of debt, it will be all but impossible to ever report a real profit. In fact, the primary reason the company is reporting heavy losses is because it is a highly leveraged company, unlike many of its competitors. We don't like to dwell on real earnings because Mr. X is the only shareholder and his game plan does not worry about real earnings.

Mr. X's plan has always been to buy the company using as little of his own money as possible, improve the operations, and then sell it later and use the proceeds to pay off the financing. Of course, he can also get a little cash for himself by charging some management fees and telling you to throw some business to a few of his affiliates. When it comes time to sell, which in this example might be within five years, he will again tout how much cash the core operations are generating (EBITDA) because without the burden of the debt that will be repaid, the company is actually quite profitable.

Risks and Rewards.

When Mr. X bought the company a few years ago, retailers were selling for an average of 8.5 times the amount of their EBITDA. Mr. X paid 12.1 times the EBITDA in order to show that his offer to buy the company was fair and that the stockholders would probably not find a better price from another buyer. In all likelihood, Mr. X was thinking that if he could improve and grow the core operations, he could resell the firm for up to 15 times the EBITDA in the future. This would make him a tidy profit.

A highly leveraged transaction such as our example sounds like an easy way to make a huge profit. The risk that Mr. X faces, however, is that the economic outlook is not as bright as a few years ago. The decline in the value of stocks over the last year means that he might be lucky to even see 7 times EBITDA if he were to try and sell the company today. In addition, sales seem to be down as consumers were struggling with high gas prices. While gas prices have subsided, it may take a few more months until consumers start spending again, so you had better not count on your bonus this year.

As discussed above, the company has enough cash and line of credit to go at it for another five years or so. If at that time, economic conditions have not sufficiently improved, then the banks could force the company into bankruptcy. If this were to occur, the most likely outcome is that the banks would exchange all or part of their loans for stock equity, and then hope to sell the stock to be repaid.


EBITDA is just but one measure of how well a company performs. It is generally a fair means to determine how well the core operations are doing; but there can be wide variations between how each company computes the results because EBITDA is not recognized as a Generally Accepted Accounting Principle (GAAP). Thus, these calculations are unaudited.

Real earnings, or those that are audited, is the most important measure of a firm's likelihood of remaining in business. No company can continue to have losses each and every year and hope to survive. Just ask the big three auto makers why they are requesting a government bailout.

Being a highly leveraged company is not necessarily a bad thing. Most banks are highly leveraged, since every savings and checking account is really a borrowing. Unfortunately, if there is a "run on the bank" where depositors scramble to close their accounts, the government steps in and closes the bank. This is what happened recently at Washington Mutual Bank. Although they were technically solvent, they did not have sufficient cash to pay the depositors (creditors). Circuit City, which is not a highly leveraged company, recently filed for bankruptcy protection after reporting a real loss of over $400 million for the first six months of 2008. Circuit City listed assets of $3.4 billion and liabilities of $2.3 million, but it did not have the cash resources to continue operations.

Is EBITDA a good measurement? Yes if it is taken into a selective context such as calculating your bonus or trying to do a rough comparison between competitors. No if you are trying to see if you should invest in a company.



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