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Friday, February 11, 2011

The limitations of 'adjusted'/'operating' profit

Open any company presentation or listen to any analyst conference call and invariably you notice a 'pro forma'number which represents the company's efforts to reflect for perceived weakness in accounting rules. This being a company produced figure, it will(naturally!) be favorable to the company itself. Unwary investors may be caught unawares if they blindly rely on those numbers.

This post takes issue with 'Adjusted EBITDA' commonly calculated as
Net Income+Tax+Depreciation/Amortization+non cash stock compensation expense+impairment etc. This is generally seen in the IT sector but is now making inroads elsewhere also.

Now, adjusted EBITDA is useful if it a
  • Used by management to evaluate their own performance, budget,plan and set bonuses. So disclosing this number gives third party an insight into the management control system of the company. 
  • Allows a period-period 'core earnings comparison'. 
But it has its own fallacies namely(as described in Linkedlin's prospectus here

although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements;


adjusted EBITDA does not reflect changes in, or cash requirements for, working capital needs;

adjusted EBITDA does not consider the potentially dilutive impact of equity-based compensation;

adjusted EBITDA does not reflect tax payments that may represent a reduction in cash available and

other companies, including companies in same industry, may calculate adjusted EBITDA differently, which reduces its usefulness as a comparative measure.

Given these limitations:-
·         Consider adjusted EBITDA alongside(and NOT in lieu of) other financial performance measures, including various cash flow metrics, net income (loss) and other accounting based results. 

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