THERE is a confusing myth among the professional on efficacy of EBITDA and its use as a barometer to gauge the financial health of the companies. In the normal course of business scenarios investors, shareholders, bankers, mutual funds, and equity brokers focus on Cash Flow, Net Income and Revenues as the fundamental barometer to gauge corporate pulse and value. However in recent years, another measure has sneaked the prominent place in the quarterly reports and accounts of Corporate: Earnings before Interest, Taxes, Depreciation and Amortization. EBITDA is used to analyze and compare profitability between companies and industries. Investors should understand that there are serious limits to what the metric can tell them about a company. EBITDA first came to surface and in prominence some time in 1980s as testing tool for leveraged buyout proposal by the investors who examined distressed or cash anemic companies in need for financial restructuring. They used EBITDA to calculate quickly efficacy or capability whether these companies could pay back the interest on the financed deals. In a leveraged buyout deal bankers promoted EBITDA as a tool to determine whether a company could service its debt in the near term, say over a year or two. At least in theory, looking at the companys EBITDA-to-interest coverage ratio would give investors a sense of whether a company could meet the heavier interest payments it would face after restructuring. A debt with interest bearing financing which, is largely a function of managements choice carrying an interest is ignored. Taxes are left out because they can vary widely depending on acquisitions and losses in prior years; this variation can distort net income. Finally, EBITDA removes the arbitrary judgments that can go into calculating depreciation and amortization. By eliminating these items, EBITDA makes it easier to compare the financial health of various companies. It is also useful for evaluating firms with different capital structures, tax rates and depreciation policies. All the same, one of the biggest reasons for EBITDAs popularity is that it shows more profit than just operating profits. While EBITDA may be a widely accepted indicator of performance, using it as a single measure of earnings or cash flow can be very misleading. In the absence of other considerations, EBITDA provides an incomplete and dangerous picture of financial health. Here are four good reasons to be wary of EBITDA: Some financial analysts urge investors to use EBITDA as a measure of cash flow. This advice is illogical for investors: for starters, taxation and interest are real cash items and, therefore, theyre not at all optional. Unlike proper measures of cash flow, EBITDA ignores changes in working capital, the cash needed to cover day-to-day operations. This is most problematic in cases of fast-growing companies, which require increased investment in receivables and inventory to convert their growth into sales. Those working capital investments consume cash, but they are neglected by EBITDA. For example, one of the quoted companies in the textile sector in Karachi Stock Exchange depicted RS28.4 million EBITDA for the fiscal year 2008. But if you turn to the companys cash flow statement, youll see that it consumed RS48.8 million in additional working capital, which largely accounts for companys negative cash flow from operations. Clearly, EBITDA paints a rosier financial picture than other measures. Clearly, EBITDA does not take all of the aspects of business into account, and by ignoring important cash items, EBITDA actually overstates cash flow. Even if a company just breaks even on an EBITDA basis, it will not generate enough cash to replace the basic capital assets used in the business. EBITDA can easily make a company look like it has more money to make interest payments. Depreciation and amortization are added back based on the flawed assumption that these expenses are avoidable. Even though depreciation and amortization are non-cash items, they cant be postponed indefinitely. While subtracting interest payments, tax charges, depreciation and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. Lets say, for example, that a company has over- or under-reserved for warranty cost, bad debt or restructuring expenses. If this is the case, its earnings will be skewed and, as a result, EBITDA will be misleading. Remember, EBITDA is only as reliable as the earnings that go into it. Worst of all, EBITDA can make a company look less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than bottom-line earnings, they produce lower multiples. For Example consider a company the stock of which trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesnt mean the company is a bargain. As a multiple of forecast operating profits, the same company traded at a much higher 20 times. The company traded at 48 times its estimated net income. Investors need to consider other price multiples besides EBITDA when assessing a companys value. Despite its widespread use, EBITDA isnt defined in GAAP - as a result, companies can report EBITDA as they wish. The problem with doing this is that EBITDA doesnt give a complete picture of a companys performance. In many cases, investors may be better off avoiding EBITDA or using it in conjunction with other, more meaningful metrics. EBITDA shouldnt be used as a one-size-fits-all, stand-alone tool for evaluating corporate profitability. Like any other measure, EBITDA is only a single indicator. To develop a full picture of the health of any given firm, a multitude of measures must be taken into consideration. The writer is Vice President of ICMAP