The Monthly Metric: EBITDA
This edition of The Monthly Metric focuses on one of the most popular (and polarizing) measurements of a company’s overall financial performance: earnings before interest, taxes, depreciation and amortization (EBITDA).
The metric is used by investors and analysts’ evaluation of companies, as well as many procurement organizations’ vetting of potential suppliers, and is widely considered to provide the clearest view of a company’s profitability from its core operations. An EBITDA calculation excludes (1) interest and tax expenses and (2) non-cash charges like depreciation and amortization.
The “before” is the rub with detractors, who believe including taxes, depreciation and amortization in the sum can make a company appear more profitable than it actually is, one of multiple ways EBITDA can be ripe for manipulation. Those critics include the world’s most famous investor.
“It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it,” Warren Buffett told Berkshire Hathaway’s annual shareholders meeting in 2002, adding that depreciation should be considered an expense. “We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group.”
Despite the robust debate, EBITDA’s near-universal use means that supply management organizations must be cognizant of the impact they can have on a company’s performance. Such endeavors as cost reduction, process improvements and risk mitigation can positively impact EBITDA, and compelling case studies can be found among Institute for Supply Management®’s (ISM®) Trailblazer Awards and 30 Under 30 Rising Supply Chain Stars.
“CFOs who work alongside their procurement officers can dramatically improve their EBITDA through procurement-related optimization, mitigate risk through supplier resiliency and achieve a competitive advantage in the marketplace,” Jake Wojick, managing director at Accenture Strategy & Consulting, wrote in 2022.
Meaning of the Metric
EBITDA is generally determined two ways, by adding figures easily found on a business’s income statement. The first formula is calculated by adding net income, interest, taxes, depreciation and amortization; the second by finding the sum of operating profit, depreciation and amortization.
Dividing that figure by a company’s revenue produces its EBIDTA margin, a ratio that investors and analysts believe is a clear picture of profitability. For a manufacturing company, an EBIDA margin between 5 percent and 10 percent is considered good.
For example, in a comparison between hardware and home-improvement retailers during the third quarter of 2023, Home Depot recorded an EBITDA of US$6.23 billion and a margin of 16.5 percent, while Lowe’s posted figures of $3.23 million and 15.7 percent. For investors, EBITDA margin could be more attractive than the sum.
However, EBITDA is not recognized under generally accepted accounting principles (GAAP). As a result, it falls under non-GAAP disclosure requirements from the U.S. Securities and Exchange Commission (SEC), which mandates that companies reporting such figures show how they were derived from net income. The SEC also bars per-share EBITDA reporting.
EBITDA is often confused with cash flow. Marcia Williams, founder and managing partner of Brooklyn, New York-based USM Supply Chain Consulting, wrote that “profits are not cash.” She believes (1) removing the “DA” from the calculation or (2) measuring operating income are better options than EBITDA.
“Although they are non-cash items when recorded, it is a question of timing. For example, a growing business will require new machines and will replace others that are no longer working,” Williams wrote. “Without considering depreciation and amortization, companies with significant fixed assets will be overstating earnings. (The) only context that EBITDA applies is for mature businesses with little or no capital.”
Still, with EBITDA not going away, supply management organizations have tools and process improvements at their disposal to improve their companies’ figures.
The Potential Impact of Inventories
In the last year, many companies whose activities are measured by the ISM® Report On Business®, especially those in health care, have been right-sizing their inventories — aligning stock levels with demand; for example, ensuring popular products are available at their respective locations. By swapping misplaced inventory, sales can increase, directly boosting earnings and EBITDA.
Reducing inventory can also lower operational costs, but it’s essential to identify which costs will decrease. There are three factors to consider, wrote Sujit Singh, COO at Arkieva, a Wilmington, Delaware-based supply chain software provider.
Rent refers to financial costs linked to borrowing or capital. While this does not affect EBITDA directly, it remains a crucial consideration for overall financial health.
Room pertains to operational costs. For instance, reducing inventory can eliminate the need for extra storage space, directly affecting EBITDA if the business rents additional facilities. However, if a warehouse is owned, many associated costs are fixed (like depreciation), so only variable costs (for example, inventory management) will impact EBITDA.
Risk includes costs from inventory write-offs and operational risks such as theft or damage. Lower inventory levels typically lead to reduced write-offs, positively impacting EBITDA.
However, right-sizing may incur direct costs from addressing slow-moving or obsolete inventory, such as disposal, discounting, repackaging or reworking. These activities can negatively affect EBITDA.
“To the very specific question about whether or not the right-sizing impacts EBITDA, the answer is that it does so both positively and negatively,” Singh wrote. “The overall effect should, therefore, be measured very carefully.”
Other Supply Chain Solutions
ISM Trailblazer Award winner Cipla Ltd. of Mumbai, India improved EBITDA through digital technologies that revamped its warehouse and transportation management systems. Supplier relationship management is also important; a 30 Under 30 recipient achieved $673,000 in EBITDA savings in a four-month period through working with plant service vendors to find cost reduction opportunities.
Oliver Wyman, a New York-based management consulting company, notes that process improvements in such areas as demand forecasting, inventory management and route optimization can reduce supply chain costs and be “potential quick wins, yielding EBITDA results within the first year. Others require a mid- to long-term time horizon.”
Though EBITDA has its critics, it’s a critical metric in the business world — and supply management organizations are expected to be in alignment with overall company goals. As a result, it’s a measurement to keep top of mind in supply chain planning.
To suggest a metric to be covered, email me at dzeiger@ismworld.org.
(Photo credit: Getty Images/Zysman)