Why do some banks use EBITDA as a proxy for cash flow when underwriting loans?
What should they use as a proxy if not EBITDA? OCF can be volatile, CapX may have lot of one time things.
It’s a lousy proxy for cashflow but easy to calculate and nets out a lot of judgment calls people could make in the accounting to create a standard benchmark. In general, EBITDA is the metric that Wall Street uses to justify overpaying. It is a big turn off when companies start with the pro forma adjusted EBITDA shenanigans. Bisssh pleeeease, we know you don’t make any money, stop lying to people.
Because it’s easy.
^ +1
If the EBITDA coverage ratios are conservative enough and the collateral is secure, you may not need to go through all the work to get FCFF. I could easily imagine a system that says accept if EBITDA coverage is good enough, and a second tier where if it is suspect, go through and do a full FCFF analysis, or just jack up the interest rate to compensate for additional risk.
Unlike equity valuation, where you are discounting future cash flows to arrive at a present value, in loan underwriting, all you really care about is the ability to make interest payments and, barring that, secure collateral. If the ratios are conservative enough and/or collateral secure enough, it’s just not that important that CFO isn’t exactly the same as EBITDA if EBITDA is 5x total interest payments, although one would still want to test for shenanigans or outright fraud.
In equity valuation, you need a more precise estimate of cash flows because that figures into your valuation. In loan underwriting, you are just trying to see how likely it is for gross profits to be insufficient to cover interest expense.
It is also used when the borrower’s financial does not have enough detail or is suspect to make a FCF calculation worthwhile.
In the senior unsecured field, in my experience, the most used indicator in assessing credit quality is leverage, which is usually defined as Net Debt / EBITDA.
IMO, EBIT is a much better measure of operating profit than EBITDA, and EBITDA is a much better *indication* (while still a pretty poor one) of CFO than EBIT. As such, EBITDA is a sort of a compromise between earnings and cash.
I would be personally ok if everybody in finance would stop thinking in terms of EBITDA and rather in terms of CFO and EBIT. But there, it replaces 1 metric with 2.
In many instances though, EBIT is used instead of EBITDA for margins and EV multiples.
IMO it is all about having an understanding of the business and the most important part is to be consistent.
If you look solely at FCF, you might reject a financing deal that is otherwise good. For example, imagine a company with its last 5 years FCF all negative. One might conclude that it’s a shitty business. But what if that company has growing revenues, stable CFO and high margins and operates on a buy-and -build model ? In a growth phase it is fine is the company cannot cover its expansion with its CFO. At some point though, incremental profits from past capex must make FCF converge to break-even. If this company also has a conservative Net Debt / EBITDA of say, 2, and at least 30% equity, it is all in all a very bankable deal.
My point : an isolated ratio or metric isn’t worth much, unless it is very exagerated. I would never, ever finance a company with negative EBITDA, 10% equity or negative CFO. These are all deal-breakers for me.