Classification Choices
Once the income statement is adjusted or corrected for timing differences, the other major issue is classification. In other words, which profit number do we care about? The question is further complicated because GAAP does not currently dictate a specific format for the income statement. As of May 2004, FASB has already spent over two years on a project that will impact the presentation of the income statement, and they are not expected to issue a public discussion document until the second quarter of 2005.
We will use Sprint’s latest income statement to answer the question concerning the issue of classification.
We identified five key lines from Sprint’s income statement. (The generic label for the same line is in parentheses):
1. Operating Income before Depreciation and Amortization (EBITDA) Sprint does not show EBITDA directly, so we must add “depreciation and amortization” to operating income (EBIT). Some people use EBITDA as a proxy for cash flow–as depreciation and amortization are non-cash charges–but EBITDA does not equal cash flow because it does not include changes to working capital accounts. For example, EBITDA would not capture the increase in cash if accounts receivable were to be collected.
The virtue of EBITDA is that it tries to capture operating performance–that is, profits after cost of goods sold (COGS) and operating expenses, but before non operating items and financing items such as interest expense. However, there are two potential problems. First, not necessarily everything in EBITDA is operating and recurring. Notice that Sprint’s EBITDA includes an expense of $1.951 billion for “restructuring and asset impairments.” Sprint surely includes the expense item here to be conservative, but if we look at the footnote, we can see that much of this expense is related to employee terminations. Since we do not expect massive terminations to recur on a regular basis, we could safely exclude this expense.
Second, EBITDA has the same flaw as operating cash flow (OCF), which we discussed in this tutorial’s section on cash flow: there is no subtraction for long-term investments, including the purchase of companies (since goodwill is a charge for capital employed to make an acquisition). Put another way, OCF totally omits the company’s use of investment capital. A company, for example, can boost EBITDA merely by purchasing another company.
Taken From : Advanced Financial Statements Analysis