Invested Credit

0_02909.jpgOver the last few articles we have been discussing the pros and cons of using EBIT and EBITDA metrics to choose investment opportunities. While the revenue-bias of the metric can be fairly well balanced out by balancing out the evaluation with a few more conservative cost-side metrics, it is important to understand exactly what it is that we need to be using these checks and balances, if nothing else for the sake of motivation.

During periods of economic growth, companies begin to aggressively expand their operations so as to make the most of the macro opportunities while they are available. While the smaller companies will do this by aggressively pursuing increased revenues through sales and distribution, larger companies will begin actively acquiring the smaller ones in order to keep their percentage rate of expansion at an acceptably high level. Eventually, this leads to an environment in which leveraged buy-outs become a popular venue for acquisition.

However, as companies continue to pursue debt for the sake of expanding their enterprise value, interest rates will begin to climb to fight the ensuing inflation. This will in turn force companies to find alternative means of financing their acquisitions. Read the rest of this entry »

interest-calcHaving looked at how EBIT and EBITDA can support an investor’s pursuit of understanding what kind of impact management’s decisions are having on a business’ revenue generating capabilities, it is important for us to take a moment to also look at some metrics that can also be used to counter-balance the income-bias that EBIT-based metrics create for us. By balancing the returns of EBIT(DA) against the costs associated with leverage and depreciation-based performance metrics, we can create a much more encompassing picture of exactly how it is that a company is being run.

The first metric that can be used to evaluate the cost implications of management’s decisions is called the Interest Coverage Ratio. The ICR defines the proportion of interest expenses that is covered by EBIT (ie. ICR = EBIT/Interest Expense). The lower the ratio, the more debt that a company is servicing, and the less ability it has to pay off its debts based on its incomes. In general, an ICR of less than 1.5 is considered to indicate that the company’s operational direction has overleveraged itself.

When looking at how the formula is built, it becomes apparent that a change in ICR is an effective metric for counter-balancing EBIT because of the way in which it takes the fundamental costs of debt into consideration against the metric itself. This results in a metric that demonstrates how it is that management’s preference for leverage has exposed it to risk in the hopes of boosting top-line performance. This means that, if ICR is decreasing while EBIT is increasing, management is taking on debt faster than it can earn its way out of it. Read the rest of this entry »

earnings-interestWhen looking at investments, there are two key metrics that analysts return to over and over again to define a company’s profitability. While both EBIT and EBITDA have been surrounded with controversy throughout their introduction to the capital markets, they continue to serve as an invaluable tool for understanding exactly how profitable a company is for shareholders, and what kind of impact both depreciation and interest expenses erode away the margins.

The Earnings Before Interest and Taxes metric was originally introduced to measure the amount of money that investors have a claim to before the fundamental costs of debt and tax are taken out. This is done to measure the operating profitability of the company. Understanding how it is that interest expenses represent the cost of leveraging the company, and taxes are imposed upon the company by outside powers, they do not so much reflect the benefits of operating decisions as they do the costs and implications of them.

As such, EBIT creates value for analysts in the way that it demonstrates the ability of management to create nominal returns through their decisions and actions. That being said, it does not take into account the expenses associated with those decisions, and should be taken in consideration against a comparison metric that does exactly such. Read the rest of this entry »