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Joan Massons (Lic&MBA 66/PhD 07) and associate professor in ESADE’s Financial Management and Control Department, brought ESADE’s annual Refresher Program series to a close on December 17th with his conference about two ratios often used in the business sector and which are, in his words, “not only useless but misleading". This business consultant spoke to a full house – giving the audience the pleasure of listening to one of his lectures without having to sit one of his exams.
Ebitda and Roce: two ratios to be done away with
Dr Massons, who has a PhD in Business Administration, said quite emphatically that these two enormously widespread ratios should be done away with for three simple reasons: the magnitudes in the two ratios are not comparable, so the cause and effect relationship is an abysmal failure; these ratios can be used to demonstrate exactly the opposite of what is actually happening in a company; and the previous two comments can be confirmed by professional financial analysts.
Joan Masson based his statements on the work he did to confirm his theory at the CTM (accountants’ association), where no one in the large audience of accounting experts said a single word in defence of these ratios despite using them and actually admitted that they were shoddy. His talk focussed on four indicators and provided plenty of examples to illustrate them.
Ebitda: Financial liabilities
Dr Massons began by describing the Ebitda / financial liabilities ratio as “rubbish because of its conceptual failings. Although the aim of this ratio is to analyse a company’s ability to use its actual cash flow – as measured by Ebitda (Earnings Before Interests, Taxes, Depreciation and Amortization – to deal with its financial liabilities, the ratio is not effective because of the wide range of different criteria used to define financial liabilities. Massons said that the only debt that could reasonably be included in an Ebitda ratio would be the long-term borrowing provided by a bank, a company in the group or suppliers, but even these ratios would be fraught with considerable failings.
Dr Massons then went on to discuss ROCE (Return on Capital Employed), a ratio which he dismantled completely, arguing that it is only still in existence because of obsolete models which companies would rather cling to than contemplate the changes which banks have undergone over the years. Suppliers’ credit is now no longer the only useful form of credit. It is, in fact, cheaper to ask a bank for a loan because the idea that suppliers give free credit is simply not true. Discounts for prompt payment are an indication that this “free credit is underpinned by quite a high interest rate.
In reference to the ratio of Ebitda to loan interest, Dr Massons mentioned the Standard and Poor's ratings which markets use as a benchmark – but which do not necessarily reflect reality. “It’s possible to show that companies with very different financial circumstances may have the same rating and that companies in a better financial situation than others are sometimes rated worse. He then said that the EBITDA to net sales ratio is also based on a conceptual error.
Ebitda: Net sales
As regards the EBITDA to net sales ratio, Prof. Massons explained that a company that invests little in capital will have lower amortisation costs than a company investing a great deal in capital. As a result, the EBITDA / sales ratio of the first company will be lower than that of the second. However, this does not mean that the first company’s finances are necessarily worse the second’s.
Despite his forceful criticism of EBITDA, Prof. Massons nevertheless expressed his faith in valuing companies on the basis of ratios concerning differences in their current financial budgets. “But ratios cannot, as is usually the case, be based on items which are essentially unrelated.
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