the leverage ratio is computed as debt/EBITDA why is it computed over EBITDA rather than NI? The only argument I can think of is that targets are acquired and valued based on their CFs. EBITDA is a proxy for CF. However, a firm “real” CFs are affected by interest and taxes. When we have EBITDA rather than NI, the denomintor will be higher, and this will cause a lower coverage ratio. insights?
EBITDA isn’t a really good proxy for cash flow as you will learn in level 2, but the reason why you look at debt to EBITDA (which, by the way, there are MULTIPLE leverage metrics that bankers use) is because EBITDA takes into account potential cash flows that are available to all stakeholders, not only equity holders (which would be the case with NI since you’ve already backed out interest expense). you care about EBITDA because you want to have some idea what types of potential cash flows would be available to the debtholders too
Interest and taxes change depending on the specifics of a companies capital structure. When you purchase a company, you have a choice on how to capitalize so when valuing a company, you want to remove those items. Cash flow (operating cash) also takes into account changes in working capital, which can be highly manipulated by management and often fluctuates significantly from quarter to quarter for a lot of companies. EBITDA is a crude metric to use in determining leverage, but is fairly easy to get to, which is another another plus. No one cares about NI. I work in HY FI…i cant remember the last time i heard it mentioned at the office.
aic Wrote: ------------------------------------------------------- > Interest and taxes change depending on the > specifics of a companies capital structure. When > you purchase a company, you have a choice on how > to capitalize so when valuing a company, you want > to remove those items. > > Cash flow (operating cash) also takes into account > changes in working capital, which can be highly > manipulated by management and often fluctuates > significantly from quarter to quarter for a lot of > companies. > good explanation > > No one cares about NI. I work in HY FI…i cant > remember the last time i heard it mentioned at the > office. that you work in HY FI probably has a lot to do with it
Agreed with AIC. Basically you value it off EBITDA because using ebitda removes the affects of capital structuring decisions by the target firm. By removing the capital structuring decisions, you are able to better value the business in terms of how it fits withint the acquirers organization. In simple terms.
This is what I think. Please do correct me if am worng. In Ibanking the use of market approach to find comparable companies or transactions is very important. When one prices a acquisition or transaction, one would look what a potential market participant would do. In order to do this, one would look at comparables with similar operational risks. EBITDA serves as a very good measure here. The good thing about EBITDA is that it is not affected by changes in capital structure (Eg: Issue shares to pay of Debt. EBITDA is not affected, but NI will be). By using Debt/EBITDA one can get an idea, similar to a “payback period”, as to when the “operations of the business” will be able to pay back the debt as opposed to the financing of the business. To grow a business the operational growth and sustainability is the key. EBITDA captures this quite well.
sid3699 Wrote: ------------------------------------------------------- > To grow a business the operational growth and > sustainability is the key. EBITDA captures this > quite well. ah…but EBITDA also doesn’t include considerations such as working capital investments and capital expenditures the way free cash flow to the firm does, which is why buyout shops are so focused on FCF’s. that being said, EBITDA is a pretty standard valuation measure for some of the reasons you mentioned, though the argument that EBITDA serves as a very good measure for comparing companies with similar growth and operating characteristics actually has much more to do with the valuation multiple than the EBITDA number itself
Because EBITDA by way of D&A charges is manipulated or pre-arranged by the accountants in these public co’s to ensure that they continously beat earnings. To boost EPS, they maximize the useful life of the assets and they’re not too aggressive on stepping up the assets when acquired, so this results in longer useful lives and lower stepped up asset values, therefore lower D&A charges which maximizes EPS for the quarter. This is all on the GAAP side and not on the Tax books. To avoid all these accounting tricks analysts focus on EBITDA which is a less prone to accounting tricks and manipulations as all non-cash D&A charges are fully neglected.
A better way to measure leverage ratio would probably be Debt/FCF But because FCT fluctuates from year-to-year, people use EBITDA as a proxy, since EBITDA is easily calculated and tend to be more consistent y-o-y.