April Fooled by EBITDA – Part 2
- Rupam Deb
- Jun 8, 2019
- 3 min read
Fooled by EBITDA – Part 2
You can read the first article of this 2-Part series here.
We present a short case study below to explain the concept discussed in the ‘April Fooled by EBITDA – Part 1‘
You can also watch the video for the case study
Let us take the example of Hypebeast Ltd., a business which is growing quite fast. This a business that is listed in HK and is beautifully growing their revenues, Operating Profits and Net Profits have grown at a very fast pace over the last few years. The Operating and Net Profits went through an initial dip but over the last 3 years they have exploded.
And as a result their EBITDA also has exploded over the last 3 years
The quarterly growth in revenues and net profits (picked up form the company presentation) make potential investor salivate
However the reality is a bit different and that comes out by taking a look under the bonnet. Let’s take a closer look at the current assets and the current liabilities:
There are a few different ways to calculate working capital. The one which we typically use is Working Capital = (Receivables+Inventories) – (Accounts Payables)….depending upon the nature of the business, we could decide to add the prepaid expenses to the working capital
[The other way of calculating working capital is simply = (Current Assets – Current Liabilities)…..However the specific method we use to calculate working capital is not that important. It is just a convention. The core idea is this is the capital necessary to run the day to day operations of the business]
Year ending March 2014, the working capital needed was = HKD (15,369+5123) – HKD 4103 = HKD 16,389…..and this was the working capital required to support HKD 72,833 of revenues
In the year ending March 2018, the working capital needed shot up to HKD (85,932+28,990) – HKD 7,245 = HKD 107,677 to support a revenue of HKD 385,079… If we look at the Sept 2018 Balance Sheet (the last published B/S… they do not publish their B/S or C/F statements with every earnings), the working capital required shot up to HK$ 129,068
So in other words in the 4 year period since the company went public, to support a revenue growth of CAGR 51.6%, the working capital requirements grew by a CAGR of ~ 60%
This is clearly not sustainable. All these inefficiencies (the big divergence between revenues and working capital needed to support the revenues) do not get captured by their spectacular EBITDA growth…and they are of course attracting lot of praises from the ‘EBITDA tracing’ analysts… along with patting their own backs for their spectacular revenue growths.
The picture becomes crystal clear if someone looks at the cash flow statements of the business. It is quite easy to see how these factors (that are not captured by the EBITDA) have affected the Operating Cash Flow and the Free Cash Flow of the business.
The problem is the company releases their cash-flow statements only once a year, and hence to understand how well the business is actually performing in generating free cash for the owners, one needs to wait till the annual results are out.
So to summarise, it is especially important to dig into the balance sheet & the cashflow statements to understand the risks that are lurking behind the eye-popping growth numbers. While we love fast growing businesses, we are partial towards those that can produce that growth without needing much capital… and when it comes to “EBITDA”, we ignore it completely.
You can read the first article of this 2-Part series here.
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