EBITDA / EBIT AND CASH FLOW BASED ICRs : A COMPARATIVE APPROACH IN THE AGRO-FOOD SYSTEM IN ITALY Mattia Iotti –

The interest coverage ratios (ICRs) are used to qu antify the ability of firms to pay financial debts; ICRs are then considered by banks such as covenants in the financing term sheet, and are used by researchers and the rating a ge cies to estimate the probability of default of firms. Typically, ICRs calculation is based on p rofit margins, such as EBITDA and EBIT; EBITDA and EBIT approximate, but do not directly ex press, cash flows available to pay financial debts. The article aims to evaluate wheth er ere are significant differences in results using ICRs based on EBITDA or EBIT and ICRs based o n different definitions of cash flow (CF). The application is made to a sample of firms characterized by high absorption of capital operating in the Italian agro-food sector. The arti cle highlights that there are statistically significant differences using ICRs EBITDA and EBIT based and ICRs based on different CF definitions.


Introduction
Several studies were conducted about the general theme of assessing a firm's capacity to sustain the financial cycle in order to be able to pay the cost of debt and to refund the financial debts borrowed in terms of net financial position (NFP).The firm's ability to support the financial cycle does not reside only in the ability to generate profit, but it is the situation in which the cash flows generated by operations are sufficient to pay the cost of debt and refund the debt; for this purpose interest coverage ratios (ICRs) are applied.These ratios express the firm's ability to pay the cost of debt traditionally using the profit margins generated by operations, such as EBITDA (earnings before interest, taxes, depreciation, and amortization) and EBIT (earnings before interest and taxes).However, EBITDA and EBIT do not express directly cash flow (CF) available to pay the cost of debt, but approximates CF.If ICRs calculated with EBITDA / EBIT based approach are different from ICRs calculated with CF based approach it is possible to state that the use of ICRs EBITDA / EBIT based approach provides distorted information about the firm's ability to sustain the cycle of indebtedness; it could then be useful to modify the traditional approach to ICRs ratios, expressing these with a CF based approach, especially for firms with a high level of capital requirement such as agrofood firms.This type of firms is a part of the agro-food system defined as the set of interdependent elements with the aim to satisfy food needs of the population in a given space and time (Malassis 1979;Malassis and Padilla 1986).
The article is divided into five parts.This part is the introduction of research that explains the reasons and objectives of the work; the second part is the literature review that explains how the work fits within the framework of studies already conducted and what new elements it provides; the third part describes the methodology used to calculate the ratios and sample selection; the fourth part discusses the data analysis and empirical results obtained; and the fifth and final part outlines the conclusions of the work, also expressing the limits and possible future research developments.

Literature review
Financial ratios are used (Barnes, 1987) to evaluate the firm's capacity to repay its debts, to quantify business and managerial success and even to consider the statutory regulation of a firm's performance.The ratios are applied for an easier comparison between different firms; in fact, they are more significant than absolute values in comparison (Barnes, 1987).Whittington (1980) identified two principal uses of financial ratios.The first is to compare a firm's ratio with a general standard, and the second is in order to estimate empirical relationships also for predictive objectives.The former dates back to the end of the nineteenth century when US banks started to apply the ratio of current assets to current liabilities to evaluate firm's credit rating (Horrigan, 1968;Dev, 1974;Ohlson, 1980, Hillegeist et al., 2004).In 1919 du Pont Company began to use a ratio system to evaluate its operating results, starting the application of financial ratios for managerial purposes.The bankruptcy prediction literature starts with the seminal work of Altman (1968) that tried to explain corporate bankruptcy status in the United States applying accounting and financial ratios.The importance of these ratios is considered in several research studies (Leland, 1994 and1998) where it is shown that an interest coverage ratio covenant could reduce asset volatility.The covenants often considered in bank loan agreements (Gray et al., 2006) are leverage and current ratio, interest coverage ratios are also frequently used, expressing as EBIT or EBITDA to interest expense ratio, having an earnings based approach.These are the most important financial covenants in terms of frequency as expressed in different studies (Dichev et al., 2002;Demerjian, 2011).
The ratios are also applied by rating agencies and banks to assess the rating of companies, in particular (Dothan, 2006) banks use ratios that express the ability to pay debt service (interest coverage ratios and cash flow measures), profitability (return on equity and return on assets) and leverage (debt to assets and debt to equity ratio).The banks usually include the minimum interest coverage ratio (ICR) that the firm must comply with in the term sheet for financing; the text of the covenants by the definition of the minimum ICR could be in terms of earnings before interest and taxes (EBIT) and/or in terms of earnings before interest, taxes, depreciation, and amortization (EBITDA).EBITDA is an accounting measure frequently recommended as a proxy for cash flow; the definitions of accruals versus cash flow were conducted also by Healy (1985) and Sloan (1996); these researchers have been considered the standard in the accounting literature until the introduction of a more comprehensive model by Richardson (2005); this model is considered useful in explaining the financial performance and the relationship between accounting and cash flow data.Some researchers (Esty, 2004) use the cash flow based ICRs approach in analyzing project finance operations.An interesting paper (Trejo-Pech et al., 2006), exploring the relationship between earnings (EBITDA) and the cash flow measure for agro-food firms data in USA, shows that EBITDA differ from CF and should not be used as a CF proxy.We believe that the work of Trejo-Pech has the advantage of making the analysis of comparison between EBITDA and CF in a specific business sector, namely the agro-food firms.In fact, different sectors may have different dynamics of absorption of capital in fixed assets and working capital; in this way it could not be possible to compare sectors that have different characteristics in terms of production, investments, revenues and payments cycle.In Italy, some researchers (such as Dono et al., 2010) have analyzed the role of sustainability indicators of the business cycle, including ICRs, in the case of agricultural firms evaluated by public agencies in order to test the firms' access to state funds.In some other Italian studies (as in Cupo et al., 2008) ICRs were applied to analyze agricultural firms credit standing considering Basel II Accord.We intend to expand the work of Trejo-Pech, also considering the work of these Italian researchers, applying ratios that express the ability to pay financial debts with a methodology considering earnings and financial ratios net of financial charge.

Methodology
The economic approach quantifies the result of the management cycle in terms of profit considering the moment in which the value is generated by the firm's activity; this is in fact an accounting approach; the financial approach considers the management result in terms of cash inflow and outflow, as streams of money (Kwon, 1989;Copeland et al., 2000).The economic approach uses an analysis of positive and negative voices of income to calculate profit.We can express the economic approach, defining the value of production, for a generic time t, in the income statement, as follows: where S t are sales at time t, I t and I t-1 are inventories at time t and t-1, respectively; ∆ It,t-1 is the variation of inventories between time t-1 and time t.The value of production (VP) is a stream value (Dechow et al., 2002).The operative monetary costs are raw material costs (M t ), costs for services (S t ), rent and leasing costs (R t ), labor costs (L t ), others operative costs (O t ).In the income statement we summarize non-monetary operating costs as amortization of tangible and intangible fixed assets (D t ) and depreciation and risk provisions (A t ).The balance of financial operations, in terms of interest income and interest expenses is expressed as follows: X is an extraordinary income while p t X is an extraordinary expense.We can then express the income statement as follows: where EBITDA approximates the creation of liquidity about the costs, such as net of nonmonetary costs ( The financial approach differs from the economic approach; the economic approach quantifies intermediate income margins while the financial approach expresses different types of cash flow available.The cash flow statement is the table used to quantify the cash flow generation (Wallace et al., 1997;Krolick, 1998;Penman, 2004) where CF t is cash flow at time t, OCF t is the operating cash flow at time t, UFCF t is the unlevered free cash flow at time t, FCFE t is free cash flow to equity at time t, NWC is net working capital.We have ∆ + NWC t,t-1 =>∆ -OCF t,t-1 expressing that an increase in net working capital implies an increase in absorption of liquidity that reduces operating cash flow and vice versa in the case of negative variation (∆ -NWC t,t-1 =>∆ + OCF t,t-1 ).An increase in inventories (∆ + I t,t-1 ), that is a positive income voice, implies a reduction in the operating cash flow: Given OCF t , the liquidity absorption due the fixed asset investment has an effect on UFCF t , having that [(FA t -FA t-1 ) -(D t + A t )] > 0 => ∆ -UFCF t,t-1 , and vice versa.UFCF t is therefore the cash flow available, given the investments in fixed assets, at time t, to remunerate the financial debt and equity capital.
Given the income statement and cash flow statement structure, we would propose in the article a panel of 12 ratios that are applied to the firm's sample date, also considering comparisons between different ratio's results.The ratios are divided into 2 categories; the ratios from S1 to S6 are marked with "ea" letters expressing an earning approach and assume the denomination from S1ea to S6ea; the ratios from S7 to S12 are marked with "cfa" letters expressing a cash flow approach and assume the denomination from S7cfa to S12cfa.The traditionally formulated ratios are expressed with an asterisk (S1ea*, S2ea*, S3ea*, S4ea*), where we consider S1ea* and S2ea* as ICR with economic approach (respectively EBITDA and EBIT based ICR); the ratios suggested in the article, if characterized by innovation considering a financial value in the evaluation of sustainability, are marked with two asterisks (S7cfa**, S8cfa**, S9cfa**, S10cfa**), where S7cfa** and S8cfa** are ICRs with the financial approach (respectively OCF and UFCF based ICR).We use OCF and UFCF because we do not consider CF adequately expressive of cash flow available to pay the cost of debt as it does not consider the absorption of financial resources due to the cycle of working capital.The ratios that we consider innovative because of the expression of ability to pay NFP with a value net of the interest charge are indicated with three asterisks (S5ea***, S6ea***, S11cfa***, S12cfa***), where S5ea*** and S8cfa*** have the earning approach while S11cfa*** and S12cfa*** concern the financial approach.
Data analysis was conducted on a sample of 250 firms of the agro-food sector operating in 4 northern regions of Italy (Piemonte, Lombardia, Emilia-Romagna and Veneto).The data was made available free of charge by the analisiaziendale.itcompany and it was randomly drawn from the financial statements in the AMADEUS database considering 2005 as the extraction year; the data extraction covers the 5-year period from 2006 to 2010 and uses the financial statements filed by corporations and cooperatives each year at the Registrar of Companies.In the sample, 87 firms operate in the meat sector (ATECO-ISTAT code 15.1), 4 operate in the fish transformation industry (ATECO-ISTAT code 15.2), 51 operate in the vegetables preserving industry (ATECO-ISTAT code 15.3), 8 operate in the oils and fats processing industry (ATECO-ISTAT code 15.4), 67 operate in the milk and dairy industry (ATECO-ISTAT code 15.5), 33 operate in the pasta and bakery products industry (ATECO-ISTAT code 15.8).These types of firms are interesting because several studies (Iotti et al., 2011) have shown that in agro-food there is a high capital absorption in the cycle of fixed assets and in the working capital cycle; this is due to processing of agricultural raw materials that often requires high investments in plant and machinery and also determines the absorption of capital due to the aging cycle of production, especially for cured meats and hard matured cheeses.

Data analysis and empirical results
Data analysis was carried out by verifying the assumptions made in 8 equal means for couples of financial ratios.The analysis was conducted with the parametric approach (paired sample Student's t-test).The results of the analysis show that the null hypotheses (equality of means) must be rejected at 95% level of significance for all couples of ratios analyzed using the parametric approach.
The Kolmogorov-Smirnov D statistic shows that all distributions of the ratios do not follow the normal distribution; in past years, several researchers have shown the non normality of the financial ratios distribution in their analysis (McLeav, 1982;Barnes, 1982;Ezzamel et al., 1987).
Therefore, a non-parametric approach was applied for paired data (Wilcoxon paired sample ttest) to test the null hypotheses (in this case equality of medians).We can then reject the null hypotheses for all pairs of ratios having 95% level of significance with the parametric approach.
The research can then show some remarkable results in terms of application: 1.The ICRs EBITDA and EBIT based (S 1ea* and S 2ea* ), with the earnings based approach, are significantly different compared to ICRs OCF and UFCF based (S 7cfa** and S 8cfa** ), with the cash flow based approach; we then suggest to apply the cash flow based ratios; therefore, the application of ICRs earnings based, both in the quantification of bank covenants for credit operations and the analysis of the ratings, leads to a distorted result; this result is significantly different than the real result that could be calculated with the ICRs cash flow based.
2. The ratios expressing the firm's capacity to repay financial debts, EBITDA and EBIT based (S 3ea* and S 4ea* ), with the earnings based approach, are statistically different if compared with OCF and UFCF based ratios (S 8cfa** and S 9cfa** ), with the cash flow based approach.We then suggest to apply the cash flow based ratios; the S 3ea* and S 4ea* application, in order to quantify covenants in financing operations and to quantify the firm's rating causes a distorted result; this result is significantly different than the real result that is calculated with the S 8cfa** and S 9cfa** cash flow based ratios.

3.
The ratios applied to express the firm's capacity to repay financial debts EBITDA and EBIT based (S 3ea* and S 4ea* ) and OCF and UFCF based (S 8cfa** and S 9cfa** ), do not express this attitude in a correct way; in fact, the analyzed couple of ratios (S 3ea* and S 5ea*** , S 4ea* and S 6ea*** , S 9cfa*** and S 11cfa*** , S 10ea** and S 12cfa*** ) show that the ratios not considering the interest charge, as traditionally applied (S 3ea* , S 4ea* , S 9cfa*** , S 10ea** ), are significantly different than the suggested ratios that are calculated considering the cost of debt (S 5ea*** , S 6ea*** , S 11cfa*** , S 12cfa*** ); if we apply traditional ratios we could overestimate the firm's ability to repay its debts and, therefore, provide distorted information on the sustainability of debt service.

Conclusion
The evaluation of the cost of debt payment, carried out applying ICRs, and the analysis of the ability to repay financial debts, are essential to quantify: a) the sustainability of the business cycle, b) the calculation of the firm's rating, c) the covenants in bank financing operations, d) the managerial assessment of sustainability of the business cycle.This importance is higher in firms where the economic and the financial cycle have a time lag, due to the absorption of capital in the cycle of investments in fixed assets and in working capital, as in the case of agrofood firms.Firms with a greatest mismatch between the economic and the financial cycles often operate in the aging of meat and dairy products, such as cured meats and hard cheeses; in this sector of the agro-food system it would be useful to perform future studies.
The article proposes the use of ICRs expressing directly the financial ability to pay the cost of debt (ICRs cash flow based), and ratios that express the repayment of financial debt with cash flows net of the cost of interest charge.All the suggested ratios are statistically different compared to the traditional ratios used in banking covenants and, often, for the calculation of the firm's rating.The analysis thus shows that it is preferable to use the suggested ratios rather than the traditional ones; the former are able to express the sustainability of the business cycle more correctly.
The analysis is based, however, on a sample of only 1.207 observations of Italian data, and for some agro-food segments.It may therefore be important, even for the work of other researchers, that research proceeds to test the suggested ratios in other sectors and in other states to get a more reliable evaluation of the correctness of the suggested ratios.