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Focus on certain financial metrics could lead to poor operating decisions.
Many companies focus on improving their EBIDTA under the impression that it would lead to the right operating decisions. Their EBIDTA focus is often triggered by investors and financial analysts, who use EBIDTA multiple for valuations. Is EBIDTA a good measure for operating decisions?
The drawback of EBIDTA is that it ignores interest and depreciation, which are related to capital investments. It places no penalty on surplus inventory. No penalty on poor CAPEX expansion. If you spend a large amount on automating certain tasks and reduce the workforce only marginally, EBIDTA would improve. Decisions on outsourcing versus in-house manufacturing also get vitiated.
Net Profit is often used to overcome it. However, it ignores financial leverage and use of surplus cash. Converting debt to equity improves Net Profit. If there is surplus cash in the system which is used to buy more inventory, it doesn’t impact Net Profit.
TOC community uses Throughput Accounting, measuring Throughput (T), Investment (I) and Operating Expense (OE). It penalises surplus inventory and poor CAPEX decisions. It is a far better set of measures than EBIDTA and Net Profit. However, if higher I increases T without affecting OE, its evaluation gets subjective, based on ROI computation.
Economic Value Added (EVA) as a financial measure simplifies it by presenting a single metric, which improves flow and penalises wrong decisions of surplus inventory as well as poor CAPEX.
Which financial metric do you currently use to take day-to-day operating decisions?