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Is EBITDA a Fairy Tale? – Part 1

You may wonder why a retired ENT doctor would tackle a dry financial topic like EBITDA, a financial acronym used for examining earnings— Earnings BEFORE deducting costs for paying Interest, Taxes, Depreciation, and Amortization. More simply, it equals net income plus interest, taxes, depreciation, and amortization. It is not GAAP (Generally Accepted Accounting Principles) Accounting, as mandated by the Securities Commission, but it may be useful in comparing companies’ profitability without factoring in financing and accounting decisions. Why talk about EBITDA? Because it relates to Lutheran Health Network (LHN) parent company Community Health Systems (CHS) and its ability to stay afloat. Most loan covenants—agreements between bank lenders and company borrowers— contain promises (covenants) relating to earnings and assurances regarding money and how it will be spent and repaid.

On the blog (…/top-five-reasons-why-ebitda-is-a…/…), Ted Gavin, perhaps somewhat tongue in cheek, says: “EBITDA, that widely-touted measure of company performance and indicator of value otherwise known as earnings before interest, taxes, depreciation, and amortization, is a fairy tale told to investors and credit managers so that they go to sleep happy instead of running for the hills. EBITDA purports to indicate a company’s pure operating performance, free of such esoteric characteristics as debt cost, tax burden, depreciation, and amortization. In reality, EBITDA is akin to a blender, into which go normal financial statements and out of which comes a number that always seems to make the subject company look better than it did when the numbers went into said blender.”

I recommend reading Gavin’s post because it points to some of CHS’s many problems. These include operating problems such as declining admissions and wages, but also paying high interest, using depreciated equipment that needs replacement, and the clinical demands (cited by both Medicare and CHS CEO Wayne Smith) that determine each patient’s reported experience. But Gavin first points to cash.

Let’s make some assumptions that are close enough to be representative:

– If CHS gives guidance that suggests $1.8 billion of earnings (the “E” in EBITDA) and…
– Deducts interest payments (the “I”) of $910 ($13 billion in debt at an average interest rate of 7%)…
– That would leave $990 million.

More than enough to pay bank interest— or so it would seem.

But then there is depreciation (the “D”). If equipment and facilities are old (like some of Lutheran Hospital’s aging patient monitors that need replacing, 20-year-old beds that are failing, and old buildings like some 50-100-year-old structures within LHN (St. Joseph Hospital and its facilities in Peru, Bluffton, and Warsaw), then depreciation may appear low because the items have already been fully depreciated. But, as Gavin notes, EBITDA may not relate to what is really happening in “asset rich companies” like CHS. Warren Buffett is quoted by Gavin, as saying “Does management think the tooth fairy is paying for capital expenditures?” Those costs come out of capital expenditures (“Capex”) trading cash for items that are also assets. The key consideration, of course, as Buffett discerned, if you are short of cash, is there a tooth fairy? We’ll answer that question—and continue our examination of EBITDA—tomorrow.