EBITDA

Why are we talking about this now?

EBITDA - earnings before interest, tax, depreciation and amortisation - is the favoured performance gauge of private equity-backed firms.

Companies being sold or floated - such as New Look, which unveiled IPO plans last week - typically report EBITDA, which may vary greatly from the more conventional pre-tax profit figure often adopted.

New Look, for instance, generated EBITDA last year of £217.6m but pre-tax profits were £2.6m. Ocado, another IPO candidate, is profitable in EBITDA terms, but not at the pre-tax level. Some potential investors are uncomfortable with a lack of pre-tax profit.

Why is EBITDA often preferred?

Because it allows measurement and comparison of business performance regardless of a company’s capital structure. Take New Look: earnings are growing. Between 2004 and 2009 the compound annual EBITDA growth rate was 12.9%. Pre-tax profits may not reflect that, but the actual performance of the business may be better than peer companies. That is the opportunity that would be bought into.

An IPO can enable the elimination or reduction of debt - effectively providing a fresh start for a company whose growth is then expected to bring rewards to the new investors. Reduced debt means a lower debt servicing cost and more money available to pay dividends and invest. New Look intends to raise £650m through its IPO, which it said is to provide it “with the flexibility to fund its continued growth”.

So is debt not an issue then?

Companies have to pay interest on debt, so it has become a big bugbear in business. Regardless of how good EBITDA might be, debt can still be an issue, as is the case with New Look.

The retailer used controversial PIK notes to raise £359m to pay a special dividend in 2006. It is understood that as much as £600m of the £650m proceeds from the float will be used to repay the notes - a substantial proportion of which are owned by investors who received the original special dividend.

Unless potential new investors are convinced that a company still has plenty of growth to go for, they may baulk at the idea of clearing debt on the promise of a happy future.

Ocado also carries substantial debt. It has spent heavily on developing its cutting-edge infrastructure and systems, potentially giving it an advantage over competitors. Despite pre-tax losses its growing EBITDA would be taken by many potential investors as evidence of the foundations for continued growth created as a result of investment.