Moving Beyond EBITDA: The Importance of Liquidity

Around the 4th century BC, the ancient Greeks believed that all matter was composed of four elements: fire, earth, air and water. By burning a piece of wood, Aristotle was able to demonstrate that, when burned, it turned into smoke (air) with the remainder turning into a measurable amount of dust (earth). Therefore, wood was composed of fire, earth and air.

A fellow philosopher, Democritus of Abedra, believed that materials in the natural world were composed of even smaller elements until one finally got down to particles that were truly indivisible; however, since he could not manage to demonstrate his ‘atmos’ principle (today’s atoms), he lost the battle for the hearts and minds of his countrymen to Aristotle.

Flash forward about 2,500 years and an idea attributed to another great philosopher, Peter Drucker: “What gets measured gets managed.” Like the ancient philosophers, Drucker knew that business was composed of key elements and results cannot be achieved or will not be believed without measurements. Two key elements of business immediately come to mind:

  • Risk – since the future is uncertain management must have controls to minimise uncertainty. Most controls create lend themselves to being measured and, therefore, managed.
  • Reward – failure to achieve profits, often measured in terms of earnings before interest, taxes, depreciation, and amortisation (EBITDA), can turn a business into ‘dust’. Management is usually incentivised to manage profits, so they must be measured.

These elements are not new to business, so what could go wrong? Judging from today’s economic results, quite a lot. The financial industry went through a near death experience – profits and share values for most companies shrank by amounts not seen in decades. Also, many companies have found themselves shut out of the credit markets and the just-in-time borrowing environment that they had become used to.These conditions have raised important issues:

  • Perhaps the links between risk and reward are not as direct as first thought, or maybe they are linked through some other force, making the management of these links ‘murky’.
  • Could it be that this missing economic element is not so easily observed (just like in Aristotle’s day), or is this force just not being measured correctly (or at all)?
  • If both Drucker and Democritus are right then this unseen force is probably not being managed (or managed well) if it is not being measured.

Perhaps it is time to move beyond EBITDA and risk and consider measuring this ‘unknown’, a third element which we will call ‘liquidity’, which has managed to damage some of the largest economies on earth.

What Business am I In?

In the perfect business there should be a relationship between three natural business elements: how much (profits); when (liquidity); and if (the risk of being wrong about how much and when).

Figure 1. The Perfect Business

Source: Financial Executives Consulting Group

Using Peter Drucker’s dictum of what gets measured gets managed, one can argue that profits have been the most managed of the three elements above, typically through the EBITDA metric. Yet, there is a problem with this measurement because it assumes:

  • Capital is free (no interest, no dividends).
  • No need for upfront cash investments in capital expenditures (capex), research and development (R&D), or acquisitions.
  • No change in foreign exchange (FX) markets (no FX gains/losses).
  • After tax income the same around the world.

Further, EBITDA as a profit and loss (P&L) metric represents only change over a period in time. What does this change affect? What about the cumulative value inherent in a company’s assets or liabilities and that which is ‘leftover’, namely equity? Without some measurements of these values they will not be managed well for those with a stake in their future outcome (i.e. when that value is transferred from one party to another sometime in the future).

Therefore, there is a need for a counterweight or balance sheet perspective (e.g. current value of a company’s global assets and liabilities) in order to supplement EBIDTA and keep it ‘honest’ over time. For example: many companies have turned to dust (Enron et al) for ‘making’ profits in the short run but forgetting to manage their company’s cumulative value. Suddenly, these companies failed because the current, cumulative value of their liabilities exceeded their assets. Clearly, the large amounts of EBITDA earned in the past were not a strong enough measurement by itself to ward off ultimate failure.

Moving Beyond EBITDA

By moving beyond EBITDA, a company can become better managed, more competitive and increase its chances of survival in tough economic situations not of its own making. Getting there will require a company to change its policies and procedures, as well as refocus its organisation’s structure around profitability and liquidity.

First, management must define what is meant by liquidity. If EBITDA is profitability in the eyes of many, then what is liquidity? One measure that is relatively straightforward is ‘free cash flow’ or operating cash flow less capex. After all, a company that can not generate enough cash to pay for its next investments in products, services, etc should not expect others (e.g. banks) to fund these needs unless there is a strong prospect of being paid back when these borrowings mature. Another metric is ‘liquidity on hand’, which is composed of cash plus other marketable assets that can be turned into cash within a short period of time, for example less than 30 days, together with available credit from reputable financial institutions.

These metrics are not exactly new , so why hasn’t liquidity been measured and managed all along? There are three key reasons:

  1. Treasury’s traditional role has been more processing than planning, or linking financial or operating cash outflows to cash on hand plus cash inflows from credit or equity sources. Treasury simply had little time to measure (manage) liquidity.
  2. Business units are rewarded for managing profitability not generating liquidity (i.e. basic operating cash flow). Besides, what to fund or when to fund it is someone else’s job in the company, such as treasury.
  3. Management is not fully aware of the global costs (internal, external and opportunity) associated with cash visibility, or its lack thereof.

Treasury’s Role in Managing Liquidity

Treasury’s traditional role in managing liquidity is one of cash processor with much of treasury’s limited resources devoted to processing transactions as shown in Figure 2.

Figure 2. Traditional Treasury

Source: Financial Executives Consulting Group

Its historical role occupied the bottom part of Figure 2, and was dictated by the need to control cash and reconcile the company’s books to bank figures since treasury had the bank contacts. While controls over past events are comforting, compliance with the ‘wrong’ controls will not address liquidity, which is a future-oriented issue (i.e. the need to match liabilities due in the future with cash which may/may not be there).

A modern treasury must be able to advance its role in the business process by anticipating not only how much is needed in the future but understanding when it is needed, in what currencies and where the least cost sources are located. This multi-dimensional chess game can create problems, especially if there is a disconnect between operations and finance. Also, treasury has been historically ‘outgunned’ by other organisational units with more staff and larger, more update systems. If a company is to move beyond the basics of profitability management, a modern treasury will need purpose-built technology in order to fulfil its role as the company’s chief liquidity officer.

The Role of Business Units

Business units are tasked with one of the most difficult jobs in the company – that of attracting customers willing to purchase high volumes of the company’s services at prices above what it costs the company to deliver them. Typical measurements of a business unit’s success are sales or EBITDA and more is better, especially if bonuses are on the line.

Because the business units’ responsibilities are difficult to execute, the link between sales, EBITDA and investments necessary for new products or markets, and where the money comes from, is overlooked or misunderstood by both treasury and the units themselves. Simply put, EBITDA is what business units are rewarded for and liquidity will just be there. Besides, compared to cost of goods sold, interest expense is small, so why worry? Business units do not seriously concern themselves about liquidity or whether the funds necessary for their investments are not available at any price due to market conditions.

This inability to integrate and measure risks and rewards taken on by the business units with the ability of treasury to obtain the necessary amounts of low cost liquidity can doom a company to finishing behind its competitors.

What Gets Measured Gets Managed

Today’s global businesses have become more complex. In addition, a business no longer has to be big to operate on a global basis or be connected 24/7 to customer needs or a competitor’s actions. While profits will continue to be prized, companies must recognise that earning more each year will not make them immune from market forces that can, in a short period of time, take away value that took years to build.

A solution to protecting value is to re-examine the conditions that impeded the forces shown in Figure 1. Companies should adopt metrics that measure the relative costs/benefits associated with changing these forces with respective to the company’s goals and relative to the market. When considering the cost side, they must include such costs as the upfront fees required by banks or other financial institutions and other terms which, if not complied with, can transfer ownership away from shareholders, as is the case with credit defaults. These ‘all in costs’ can dwarf the more traditional measure of expenses included in EBITDA, which only consider out-of-pocket staff levels. For example, banking fees for credit and cash can be a many times multiple of treasury staff itself, and often management will skimp on staff while overspending in fees.

One method which can be used to link the forces of risk, reward and liquidity is to re-examine the organisational relationships between the markets and the company using the modern treasury structure as shown in Figure 3.

Figure 3. Modern Treasury

Source: Financial Executives Consulting Group

Under this plan, business units will remain responsible for sales and operating expenses but must recognise that any enhancements to products or markets require investments the costs of which must be covered out of the cash flows they generate (i.e. business units must meet a free cash flow target as well as meet EBITDA targets). Because a company may not have liquidity on hand (as defined above) these investments and their costs could risk being subject to market forces which treasury is responsible for, such as obtaining a sufficient amount of funds at the lowest after tax cost. If the risk of acquiring funds imperils the company or raises its future costs, then such investments maybe imprudent based on predefined business goals. As shown in Figure 3, the double-headed arrows represent various flows including cash flows, accounting flows and information flows.


The forces of reward, risk and liquidity are linked and must be measured if they are to be managed. The classically measurement of EBITDA or operating profits is not sufficient by itself to indicate future value and could expose the company to future costs such as insufficient investments or the acquisition of funds at costs above that of its competitors.

By moving beyond EBITDA and adopting liquidity measures like free cash flow or liquidity on hand (or others) a company can both measure and manage its value.


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