Why EBITDA can be hazardous to your health

Income is an opinion, cash flow is a fact!

Many people have approached me after my BNN interview to ask about why do I think that EBITDA is crap. To provide an explanation, I have decided to write this blog to illustrate this point.
In my first month as a Ph.D. student at Stern, I was asked by one of my mentors, George Sorter, to sit on an introductory accounting class .  Being a CPA and having an MBA, in my arrogance I thought that I am well beyond such materials.  I stood corrected, whatever I thought I knew about accounting was turned on its head.
One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA and that cash flow information is not as important.  It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health..
To illustrate this idea let's assume the following statements for the EIC Corp (any similarity between the name and and a real company is pure coincidence):

The statements above indicate that the company is doing very well
The income statement shows incredible growth of sales, gross margin, operating income, and net income.  The balance sheet also shows tremendous growth of working capital, total assets and equity, and the only liability that it has is accounts payable.
Using conventional wisdom, we can generate the following ratios (to make things simpler I used end of the year figures for ROA and ROE):

Our conclusion, based on such information, would be that EIC Corp. is a phenomenal company. Profitability analysis shows that the gross profit ratio went up from 60% to 65%, SGA/Sales went down by 5%, operating margin more than doubled, both ROA and ROE increased. Liquidity analysis reveals that the company is very liquid as the current ratio went from 7.30  to 22.75 and the quick ratio went from 6.30 to 19! Furthermore, solvency show ratios little vast decline in the leverage of the company, thus making it less risky.

And now let's calculate EBITDA for both years:
For 2013 it is 80+100=180 and for 2014 it is 800+100=900.  The only word that comes to mind here is wow! This is so great, the company EBITDA is now five times what it used to be last year.

So, what's the problem? It turns out that if we look at the cash flow statement, liquidity is not what we think.  The company is hemorrhaging cash from operations.

The picture looks even worse when we convert the indirect cash flow statement to the direct format. It actually failed to collect any cash from its customers and its operating cash flows before interest and taxes is  a negative 1,450, in other words the company is losing cash flows from its core business.

In consequence, EBITDA and some other common garden variety analyses would mislead us to think that the company here is highly profitable and very liquid while in fact it books revenues that it does not collect and inventory is moving very slowly. One way to improve the information would be to look at days receivable (405) and days inventory (434).

Now what will happen if we apply the Beneish Manipulation Index to the case here? It gives us a probability of earnings management of amost 100% and that sales are suspicious as evidenced by the Days Receivable Index and the Sales Growth Index.

In conclusion:

1. EBITDA is not a good surrogate to cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading, as I illustrated above, to a false sense of liquidity.
2. Superficial common garden variety accounting ratios will fail to detect signs of liquidity problems.
3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
4. EBITDA just like net income is very sensitive to accounting manipulations.