Long Term Planning and EBITDA

At the depth of the Great Recession, I was approached by a client for assistance with refinancing his loan portfolio.  Today, the business is flourishing and cash flow is strong.  In any long term planning project (e.g. a five year plan), I recommend taking the viewpoint of the banker.

Successful long term planning for growth involves a clear corporate vision with respect to high level goals and the road map to achieve these objectives.  Investors and bankers are interested in the company’s track record, the economic conditions, local trends, competition and other factors which impact the success or failure of the venture.

Whether your growth plans begin with digging out of a hole or launching a new venture from scratch, you can benefit by thinking like a banker. A favorite metric used to evaluate a business plan is EBITDA (i.e. earnings before interest, taxes, depreciation and amortization).
The earnings figure used is typically Net Income (the bottom line). To arrive at EBITDA (see illustration below), any interest expenses, income taxes, depreciation expenses and amortization expenses are added back to net income.

EBITDA = E + I + T + D + A

E = Net Income

I = Interest Expense

T = Income Taxes

D = Depreciation Expense

A = Amortization Expense

A struggling business may need to refinance in order to weather tough economic times.  EBITDA analysis helps the bankers determine a business’s ability to meet loan payments.  Since the bank will replace current loans with the new facility, the interest expenses paid during the year are added back to net income.  A company reporting a net loss generally has no income tax so the impact in the formula is zero.  Neither depreciation or amortization expenses eat cash so adding back these two numbers shows the bank how much cash is available to make loan payments.

A losing company can have positive cash flow if they have significant net fixed assets. There are many issues involving the quality of fixed assets which have an impact on negotiations. Before approaching a bank for a new loan, it is wise to sell any fixed assets which do not have a positive impact on earnings potential. The cash raised in the sale of these non-essential assets will reduce the amount of the loan required.

Evaluating the sale of a fixed asset helps to understand how your profit and loss statement and balance sheet work together to produce cash. The sale price often is less than the book value of the asset. Let’s use the sale of a delivery truck as an example.

In our example, the company has decided to eliminate the unprofitable delivery service. The vehicle has no use. If the book value is $15,000 and we are offered $12,000, we would book a loss of $3,000. This produces $12,000 in positive cash flow and reduces earnings by $3,000.

Generally, the transaction will not be repeated since the truck is gone and we do not intend to replace the vehicle. The $3,000 loss should be noted so the bank may see the one time nature of the transaction. They will correctly eliminate these transactions from their analysis of future cash flow potential. We have reduced our cash required by $12,000 with no negative impact on our ability to borrow.

The key to success in making these decisions is the evaluation of the ability of any fixed asset to generate future cash flows.

Many companies delay closing an unprofitable unit because they worry about the impact on current earnings. This short sighted approach will impair future cash flow. The closing of a store which is bleeding cash will be treated as a non-reoccurring transaction. There may be additional expenses required such as penalties to break lease commitments and real estate commissions.

The depreciation and amortization expenses of any unit on the chopping block should be used to analyze the loss on the profit and loss statement. If the depreciation and amortization exceed the net loss, the store is still producing positive cash flow. Otherwise, the store is bleeding cash and is a candidate for closure.

Future earnings and cash flow will improve once any losing units are eliminated. These transactions are always shown as one time losses due to the closure of the store. In general, you go to a bank to finance the investment in fixed assets needed to achieve financial and operational objectives.

Clearing the dead wood is seen as a positive by anyone making a decision on your loan application.

In summary, cash flow is not the same as net income. The EBITDA formula helps to measure the cash flow available to meet loan payment obligations. Think like a banker. You can reduce the amount you need to borrow, improve your chance to make payments on a timely basis, and allow yourself to focus on positive activities by evaluating the quality of your fixed assets.