The gap between EBITDA and physical cash flow increases
1 January 2019 will see the effective date of IFRS 16, eliminating the classification of leases as either operating leases or finance leases as is required by IAS 17 and, instead, introduces a single lessee accounting model. This model recognizes right of use assets on the balance sheet that are subject to depreciation over the life of the lease contract. The right of use assets are accounted for at net present value, introducing an interest component to reflect the time value of money of the lease contract.
This effectively means that operating lease expenses related to for example land and buildings no longer are accounted for as operating expenses but as depreciation expenses. In addition, lease and rental payments are presented as financing activities and no longer as operating activities.
As a consequence, EBITDA increases. Though the real fanatics may consider this an excellent instrument to boost their accounting margins, it actually further undermines the value of EBITDA as key performance indicator as the gap between EBITDA and physical cash flow increases.
Corporations that rely on EBITDA as KPI should reconsider this. It is much more relevant to introduce EBIT as measure of operating profit or perhaps EBITA insofar the amortization is only related to intangible assets that are recognized in business combinations (and, in fact, one may argue that such intangible assets aid the operations and thus EBIT really is the way to go). In addition, introduce free cash flow as measure of cash, and capital employed as measure of net assets. A relevant discussion is where to position lease payments in the measure of free cash flow, as IFRS 16 requires lease payments to be presented as financing activities. One may argue that for management reporting purposes these should be included in free cash flow to allow for a cash comparison to EBIT.
Such enhanced financial reporting approach connects accounting profit to balance sheet and cash flow, allowing to measure cash conversion and return on capital employed more effectively. When applied correctly, this reduces management myopia and allows for more balanced management decisions that help optimize all aspects of the financial statements.
Changing corporate habits and moving from EBITDA-centric performance management to a broader perspective on performance management is not achieved overnight. It involves change of culture, change of skills, change of information management and potentially change of consolidation and reporting software.
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Casper van Leeuwen is a partner at Satriun Group, a European consultancy specialized in Corporate Performance Management and the practical application of CPM with enterprises.
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