Access to the capital markets is one of several critical areas, which CFOs must understand, assess and intelligently navigate. The CFO must understand the current capital structure, accurately project liquidity needs, assess the best instrument to use to introduce new funds into the capital structure and guide potential equity or debt investors to appropriately evaluate the risk they assume by investing in the proposed funding.
In dealing with investors, the CFO faces a special challenge: They must report financial results under GAAP accounting, but augment that information with insight into operational business results and opportunities. This requires a blend of respect for the required reporting structure, creativity in expanding upon that to capture any elements where “reality” may not be completely reflected and, finally, communication skills that illuminate —rather than cloud —the differences between the two.
The EBITDA Quandary
Many companies use EBITDA as one measurement of operating performance because it captures earnings before they are distorted by financing consequences (interest charges), statutory charges (income taxes) and/or accounting non-cash charges required to be reflected in the P&L (depreciation and amortization). To many, this is the “purest” reflection of the actual health of the business, free of distortions. The problem? EBITDA is not recognized as a GAAP measure. In fact, regulatory requirements actively discourage the use of this measure. Companies using any kind of an EBITDA measure must show a thorough reconciliation from EBITDA to GAAP reported income and run a higher risk of regulatory review as a consequence. This discourages use of a very helpful and insightful measurement that would give potential investors a better insight into the historical operating performance of the company.
More stories in The Director’s Guide to Capital Markets:
Fiduciary Duties in Turbulent Times
Assessing the Balance Between Debt and Equity
Navigating Post-Crisis Dynamics: A Roundtable
There is no doubt that simply (and only) reporting EBITDA would be misleading. In fact, those elements of non-operational risk reflected in GAAP net income are pertinent facts for investors to see and understand. High interest charges reflect a highly levered business, which increases risk. Taxes must be paid if there is reported income and so should not be ignored completely although the complexity of tax accounting adds confusion for many. And depreciation and amortization paint a picture of “usage” against items that have a finite life. Once depleted, the balance sheet may reflect a different level of health. Therefore, the “complete” picture must be preserved and reported, of course.
It is strange, though, that our regulatory requirements don’t encourage reporting additional insights and viewpoints into the business. While potentially confusing to some (the stated reasoning behind the rigidity) it would surely add illumination for others. One could argue, in today’s more complex investing environment of hybrid securities, diffused risk and off-balance sheet line items that those who cannot completely comprehend all aspects of financial reporting may want to think twice about being in the market at all.
There is a second aspect to this distortion of reported risk for investors as well. Any good accountant will tell you that within the GAAP reported figures there are numerous areas where judgments and estimates must be used. It is important—even critical—that investors have more insight into the approaches taken to make these estimates. Assumptions can vary widely and a set of “conservative” financial statements prepared using wildly “aggressive estimates” can be deceptively appealing to risk-adverse investors. Case in point: financial institutions showed more health than they actually held because their assessment of the liability they held as a result of shared risk (through derivatives) turned out to be pitifully off the mark.
The point is this: GAAP accounting— that esteemed, respected foundational element of regulatory filings—is not infallible. Certain characteristics of it may make sense in one arena (accounting properly) but distort results—either positively or negatively— in another arena (investment evaluation). Investors beware: simply looking at reported results will not give you a complete picture. We have all learned a painful lesson in the past 18 months regarding the need for a complete and thorough understanding of investment risk, and this requires detailed financial and operational analysis beyond GAAP accounting. Despite the challenges of reduced staffs in our current era of “lean leadership,” directors and CFOs of companies accessing the capital markets must do their homework, whether making an investment or bringing on investors.
Cynthia Jamison is national director of CFO Services, Tatum LLC.