One of the most common EBITDA adjustments is an adjustment for non-cash transactions. This means that EBITDA is reduced for inventories and trade receivables write-offs. Theoretically, inventories and trade receivables write-offs should be included here too, as both are from the accounting perspective indeed non-cash transactions. However, there is a cash component in these write-offs.
Before going to examples, let’s just remind ourselves what is the purpose of EBITDA adjustments. The purpose is to calculate a proxy for operating cash flow, be it for the assessment of debt repayment potential or for valuation of a company, when we try to define the amount of “normalised”, or “recurring” operating cash flows.
And here are the examples why inventories and receivables write-off should stay in EBITDA.
Example 1 – inventories write off
A company X procures raw materials needed for its production process. The company pays the invoice to the supplier (cash outflow). During the production process, one part of raw materials is destroyed and written-off, and as such it is recorded as inventory write-off in the income statement. Although there is no cash outflow related to this breakage of raw materials, but didn’t the company actually pay those raw materials to the supplier? If write-offs hadn’t happened, the raw materials costs would have ended in EBITDA through COGS once the finished goods would have been sold. Why should we then treat write-offs differently?
Inventories write-offs tell us how a company manages its inventories. If a fashion retailer has to write-off its old collection, isn’t it also a negative effect on cash flow, because the retailer has already paid for it and will never get the money back?
Example 2 – trade receivables write-off
A company X sells goods and records revenue and a trade receivable. The customer does not pay, and the receivable is written-off and recorded as such in the income statement. Although neither cash inflow nor cash outflow have been recorded here, didn’t the company by previously recording revenue actually improve its EBITDA? When we calculate EBITDA, we assume all revenue has been collected and all costs have been paid for. If we implied that the previously recorded sales were collected, wouldn’t it be fair to keep the receivable write-off in the calculation of EBITDA?
I have never seen that somebody adjusted revenue retroactively for uncollected revenue. If it did, it would actually be the same as if the write-offs have been kept within EBITDA! The only issue is a time mismatch, but for most companies write-offs are ongoing circumstances, sometimes higher sometimes lower in amount.
This misconception is rather common, and performed by most advisors, even the Big4. It is clear that the figures have to be polished to look shinier, but that does not mean they should not methodologically make sense.
Trying to eliminate volatility from EBITDA is legitimate, but it is not real. As an acquirer or a creditor of a company, one should be aware that the volatility exists. Cyclical companies, SMEs, fast-growing company, etc., they all exhibit inherently high volatility, no matter how hard we try to eliminate it in their figures.
Personally, I do not believe in EBITDA as a cash flow metric, not even as a proxy. EBITDA simply fails to capture many extremely important aspects for almost any company – interest expenses, taxes, working capital, capital expenditures, dividends, etc. However, it is here to stay, and we can only try to improve its quality by calculating it properly.
If you want to know the real profitability of your business, get in touch to see which adjustments really have to be used. For all other things, we will use advanced cash flow metrics.