Are you selecting the right strategic indicators? I

One of the key decisions of the CEOs and boards is to select the right key financial indicators to manage the company. Tipically, companies select EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), EVA (Economic Value Added), Enterprise Value, among others. Although companies do not select just one indicator, they tend to use one as the cornerstone for the management focus (and their respective bonuses!).

As always, making a selection has its consequences (and of course, also its advantages...). Most of the companies I have worked for use EBITDA and they have a strong focus in this indicator.

Let´s start understanding how EBITDA is calculated:

EBITDA = Revenue – Expenses (excluding interest, taxes, depreciation and amortization)

As represented in the formula, it is a measure of the current profitability of the company, not taking in account the effects of interest (from loans for example), taxes, depreciation (the decrease of value in assets) and amortization (the payment of debts, for example). In the following table, you can see the main pros and cons of using EBITDA as the main financial indicator:

So, what can happen if we choose this indicator as the reason for living? There are several things that may happen:

- Reduction of the Return on Assets (ROA) or Return on Invested Capital (ROIC) -or getting inflated in assets and working capital. Due that the fact you are focused on profitability, you may decide to use more assets (for example, buy plants) to produce more revenues, or to have more inventory (in order to have more things to sell). However, at the end, a shareholder can complain that the money he invested is not having the right margin, compared with other financial instruments.

- Because you are not taking in account the effects of depreciation and amortization, you may have a distorted vision of the cash generated by the company. Tax and amortization can erode the cash generated.

- For the shareholders, it is not enough to use EBITDA to make his/her investments decisions. It does not take a vision of the use of the assets or working capital, it does not show the company valuation or show a trend of the future of the company, so it is difficult  for him/her to decide if it is a good place to put the money in.

As a conclusion, even though is a very common indicator and is used widely to compare companies, it should not be used in isolation to manage the destiny of the company.