The recent CVM (the Brazilian Exchange Commission) Instruction 480 brought among its innovations the Formulary of Reference, which will permit the various interested parties to have a more profound and richer view on companies whose shares are traded on the Brazilian stock market.

In addition to providing new data, the formulary of reference provides the detail of information that companies were disclosing in aggregate or so inaccurate or incomplete. One of the new requirements is the need for clarification if companies publish non-accounting measures. The most common example of non-accounting measures is that comprising earnings before interest, income tax, depreciation and amortization – EBITDA.

CVM Instruction 480 states that “if the issuer either has disclosed, in the course of the last fiscal year, or has the intention of disclosing in the formulary of reference non-accounting measures such as EBITDA , he must: inform the value of these non-accounting measures; make reconciliations between the reported values and the audited financial statements, and explain why he considers that such measurement is more appropriate for a correct understanding of its financial condition and results of operations.

This providence of CVM is very welcome, since listed companies are publicizing broadly and according to specific criteria, differing among themselves, the EBITDA as a measurement in parallel to the conventional ones presented in financial statements – usually without reconciling it with the most directly comparable measurements based on accounting standards.

Preparers aim with EBITDA to produce a kind of gross cash flow of the company that serves, for example, as a measure of capacity to service the debt and shareholders’ equity, compared to the resources invested in the company (market value plus net debt). EBITDA is also used as a multiple for the evaluation of companies.

To reflect, as an approximation, the normal operating cash flow of the company, the calculation of EBITDA should consider only revenues or expenses directly related to the business and which are recurrent, ie, those that are expected to be earned or incurred in the coming years.  From net income should be subtracted the costs and selling and administrative expenses, and added the quotas in the period of depreciation and amortization, which are provisional expenditure of character and do not represent cash outflow.

The instruction missed to propose a calculation routine to put some order in the confusion regarding the calculation of EBITDA.  Among the requirements, there should be a mention to the fact that if it was made, or not, the review by independent auditors, as well as a reference point to the limitations of these non-financial measures. The use of EBITDA as an isolated indicator of cash flows of the company can lead to serious misunderstandings.

EBITDA ignores the need for additional working capital, which can be particularly severe at certain times of the business cycle. Also disregards the investments will be needed to increase the capacity and maintenance, which may exceed the value of the quotas of depreciation and amortization appropriated in the period. The EBITDA is not also a good indicator of liquidity, nor represents the resources that will be actually available to the company to pay debts and distribute dividends to its shareholders.

Revenues and expenses are constructions that are based on accounting recognition criteria. Profit is not always money in cash – even for influence of these recognition criteria, which are not uniform across firms, varying according to the characteristics of each business. In certain industries, such as capital goods and construction, the cash generated in the period may be far from the estimated EBITDA. Better to rely on cash flow.

The user should also be aware of simple rules, such that the lower the participation quotas of depreciation and amortization, the better the quality of EBITDA.

EBITDA admittedly has the force of habit and the appeal of simplicity. It produces much noise, but due to its limitations, has little effectiveness as a tool of analysis.