EBITDA is one of the best known proxies for and underlying cash flow metric used in investment banking and finance generally. EBITDA is defined as defined as "Earnings Before Interest, Taxes, Depreciation & Amortization". The advantages of EBITDA as a basic cash flow metric is that it is easy to calculate i.e. add back depreciation & amortization and net interest expense to pre-tax profit and excluding other non-cash charges and one-off non-operating items. EBITDA is also said to be a more comparable metric when comparing performance with other companies in that it takes out the distortions of depreciation/amortization which are subject to corporate policies, and the corporate policy regarding balance sheet structure as reflected by interest expense.

Whilst EBITDA is used as a basic figure for cash flow from operations it also excludes major cash usages of capital expenditure ("capex"), interest expense and taxation. Given that interest expense and taxation can be at least partially related back to capital structure these items may be excluded for a basic calculation, however, capex is a very important cash usage, just as important as other cash expenditures including personnel expenses, cost of good sold etc., that determines the future operating performance of the company through its productivity, market position and technical leadership in its market/s.

As previously mentioned, EBITDA is used as a comparable number for operating performance with other companies especially within the same industry. It is also used a multiple of price for the acquisition of companies i.e. Price to EBITDA is say 8x. This figure is then compared to other acquisitions which have been observed in the market. In my mind EBITDA acquisition multiples have two major weakness: they are subject to economic conditions at the time of acquisition i.e. irrational exuberance vs. recessionary pricing. Secondly, the multiple does not include capital expenditure required at least to maintain its operating efficiency and market position, and to at least grow a moderate level in line with general economic conditions.

Notwithstanding these and other shortcomings the investment banks and the market which set prices of acquisitions generally is invested both intellectually and monetarily in EBITDA multiple. Investors and lenders need to be aware of the shortcomings and the possible effects the overpaying for assets.

Overcoming these shortcomings, especially in relation to EBITDA acquisitions multiple, is more easy than readily appreciated but requires more work and clear thinking. The key is to produce forecast financial statements which details revenue, costs, capex, taxation and the assumptions which underpin the projections etc.. Various scenarios should be developed from the key value drivers for the company.

The projections need to be based on reasonable assumptions within parameters of economic, market, legal, cultural factors and the past recent performance of the company being acquired. Additionally, the forecast are to be as long as the debt term of the credit facility or bond.

The great advantage of projections is that you can calculate and visually see the projected cash flow which is available for debt service and equity returns. Powerful metrics such as the Debt Service Cover Ratio ("DSCR") and the Loan Life Cover Ratio ("LLCR") for debt and Net Present Value ("NPV") and Internal Rate of Return ("IRR") for equity evaluation. Scenarios can be developed based on 2 or 3 key divers with at least 2 downsides in addition to a base case. If there are any more than 3 key drivers that can adversely affect the cash flow of the company then another look at whether to lend or invest would be appropriate.