John Hussman describes for us in simple terms the difference between EBIT, EBITDA and the investor “Owner Earnings” which should be the real evaluation cash flow for a business:
Just for Kids: Let’s start a lemonade stand!
By John P. Hussman, Ph.D.
OK, boys and girls. It’s been pretty hot out lately. So we’re going to start our own lemonade stand!
What? Jimmy, Sally, and Bobby all have lemonade stands just on your block alone? See, this is why I’m a professional money manager and you’re not even out of middle school. I only have two words for you: Global Warming. It’s a New Era. That’s all you need to know. Now go and borrow $100 from your Mom.
… I’ll wait.
Got it? Great. Now you’re deeply in debt, far beyond your ability to earn income, in an industry ridiculously overburdened with capacity. Hey, we haven’t been at this more than 30 seconds and you’re already qualified to run a telecom company! See how much you’ve learned already?
Now let’s go public. Go to your Dad and offer to sell him your business for $100. We’ll still have to pay Mom back, but Dad will have a claim on everything else.
… I’ll wait.
Holy smoke, you’re a natural. Alright now. Let’s take that $200 of investor money to buy some stuff: a lemonade stand, pitchers, spoons and ice buckets. Since the lemonade stand is cheap, you’ll have to spend another $10 a week to fix it as it “depreciates,” but we’ll deal with that later.
You’ll also have to pay for some other things before we show a profit. The lemonade mix and paper cups will be part of your “cost of goods sold.” Since you’ve got a credit rating of about F-, Mom wants $10 a week “interest” on her loan. Finally, there’s the big kid. For every dollar of profit, you’ve got to give him 40 cents or he’ll give you a wedgie until you cry “Uncle.” We’ll just call him the Uncle.
You’re off to a great start! In the first week, you’ve sold $50 of lemonade. Subtract off $20 as “cost of goods sold” and the $10 that you’ve stuffed into your pocket as “selling, general and administrative expenses.” Congratulations, you’ve earned $20 in “EBITDA” – earnings before interest, taxes, depreciation and amortization. Now subtract that $10 of depreciation, and you have $10 in “EBIT,” otherwise known as “earnings from operations.” Call CNBC. Also, make sure to buy the lemonade mix and cups with an IOU and don’t replace the depreciation, so when Dad looks into your cash register, he’ll actually see $40 in “cash flow from operations,” underscoring the “quality” of your earnings. Sweet.
But let’s take a closer look at what Dad can actually claim if you actually intend to stay in business. $50 revenue, minus $20 cost of goods sold, minus $10 administrative expense, minus $10 interest, minus $10 to replace depreciation, gives $0 in “net earnings.” The good news is that you don’t owe anything to the Uncle.
Hmmm. Which number should you report to Dad? $20 of EBITDA or $0 of net earnings? Hmmm.
Wait. Even better. Let’s classify the lemonade mix and cups as an “investment.” We can also underdepreciate the lemonade stand. And we’ll write both off as “extraordinary losses.” After all, the stand wouldn’t have worn down had it not been for the existence of time, and our investment in lemonade mix and cups would have survived had it not been for the existence of customers. That leaves us with EBITDA and operating earnings equal to $40. Yes, that’s much better.
Week two. Unfortunately, the novelty of lemonade has worn off in the neighborhood, and it’s a little cooler out too. As it turns out, you’ll only be able to take in $25 a week in revenue from now on. Now we’ve got $10 in cost of goods sold, $10 in administrative costs, $10 of interest costs… Oops! We can’t even make our interest payment, much less replace depreciation. And nobody wants to buy a used lemonade stand. Suddenly, Dad’s investment is worthless, and we’ve got to default on our debt to Mom.
But hey, we can still report $5 in EBITDA! Maybe nobody will notice.