It is not hard to notice that when reporting on the operations of their companies, they most often highlight EBITDA ‘at first glance’, and only then (‘if’) the operating result, the result of financial and extraordinary activities, gross and net profit, and margins. EBITDA has significant ‘marketing’ importance for managers reporting on their companies’ operations.
The reason for this is that by excluding depreciation costs and the effects of financial activities (primarily interest and exchange rate differences), and calculating income tax, it always has the highest value compared to other segments and levels of profit and profit margins. Of the 150,000 companies that publicly published financial reports for 2021, 50,000 reported a negative net result, a loss, and of those loss-makers, 6,000 had positive EBITDA. Some of them are major market players in their sectors.
The Real Truth About Business Efficiency
Analytically interpreted correctly, EBITDA is merely a ‘quick indicator of liquidity’ (and this comes with several significant potential limitations) that, after excluding depreciation as a non-cash expense from operating expenses, observes operating revenues as inflows from operations and remaining business as outflows.
The difference should indicate how much liquidity the company generates from its operational business. One of the potential limitations relates to the problem that arose when there was a change in the structure of financial reports and extraordinary income and expense positions were eliminated. Today, extraordinary income, which are mostly one-off items, are included and reported under other income, thus concealing the real truth about the efficiency of the business in its core activity.
The second relates to the fact that the structure of operating expenses also includes items of value adjustments and provisions, which are also non-cash costs. Therefore, it cannot be said that EBITDA calculated by the ‘simple’ method (operating revenues – operating expenses excluding depreciation) always adequately indicates how much the company is a generator of liquidity (‘cash cow‘).
When presenting business results using EBITDA, from which depreciation is excluded from operating expenses, it should be understood and acknowledged that depreciation is an extremely ‘noble’ and so-called historical cost (related to investment decisions from previous periods), which, when calculated correctly (determining value, useful life, activation, …), fairly values long-term assets, opportunities, and the need for their modernization, renewal, and maintenance.
Likewise, the costs of value adjustments and provisions are important ‘anti-stress’ costs that the company uses to align its asset positions with the actual state in the market (financial assets, inventories, receivables from customers, …) and timely calculates potential risks that may lead to costs and damages in the future (severance pay, guarantees, lawsuits, …).
Three Data ‘Stars’
In general, if the thesis about good business and prospects is imposed based on only one or a smaller number of indicators, observing only year to year, it is not in line with good practices and standards of responsible economic analysis.
To assess how financially excellent, stable, and secure a company is ‘in the long run’, it is important to observe operations over a longer period, compare it with data and indicators from a well-chosen reference group, and consider multiple indicators that measure operations from various financial perspectives: liquidity, indebtedness, activity, and profitability.
There are models that partially connect this (e.g., cash gap, BEX, DuPont, Kraliček, credit rating, and others), and when they are analytically combined into a whole, good indications will emerge. It should be noted that these are more robust analytical models that have good effects when applied to large, medium, and most small companies, but in analyses of micro-enterprises, they are difficult to apply.
In ‘modern’ times (shortage and fluctuation of the workforce, along with the impact of inflationary pressures; small potential and contraction of the local market; strong and ruthless competition in global markets; low levels of digitalization, automation, and robotization of jobs and business processes in Croatian companies), the importance of three data ‘stars’ and their analysis is growing daily:
- Average monthly net salary and compensation, and the ratio of labor costs of employees and external collaborators to sales revenue and profit
- The value and share of export revenue in total sales revenue
- The value of investments in long-term material and (especially) intangible assets.
In times of crisis and stagnation, the focus on liquidity strengthens, the ability of the company to regularly settle its short-term obligations from cash on accounts, and other forms of short-term assets that can be relatively quickly converted into cash. Delays in customer payments, increasing risks of customer insolvency (bankruptcies), using pre-bankruptcy as a tool for escape or minimizing debtor obligations, increasingly difficult borrowing options, and rising credit costs are accompanying features of recession or stagnation in Croatia. In such conditions, companies primarily justifiably pay more attention to their liquidity and less to profitability.
Different Companies Cannot Be Analyzed in the Same Way
Calculating and monitoring the cash gap that interprets the effects of inventory turnover, tying receivables from customers and obligations to suppliers is a good tool for managing liquidity. Also, the financial stability coefficient 02, which treats inventories (in whole or part with current or potentially slower turnover) as a component of long-term assets and observes whether, for crisis periods (stagnation of market activities and monetization of inventories), they are adequately financed from equity and long-term obligations, is useful information for those for whom inventories are valuable and important assets (production and trade activities).
Kraliček’s quick liquidity test also provides good information related to business liquidity. However, as previously noted, its application is possible for larger companies, but not for micro.
Credit ratings published on various portals of credit agencies and companies specialized in economic analysis measure (only) liquidity, and the lower the ratings, the more they indicate potential problems and delays in payments, just as stated in the descriptions accompanying individual ratings.
When analyzing the value of certain indicators, it should be known that there are no universal reference values for indicators in economic analysis. Companies of various sizes and activities cannot be analyzed in the same way. The cost structure and balance sheets of companies engaged in services are quite different from those engaged in trade or production.
When differences arising from company sizes are added to this, it is clear that there are significant differences in analytical procedures and understanding the value of certain financial positions and derived indicators that need to be known and applied to ensure useful information for making good decisions, prevention, and minimization of risks.
