Adjusted EBITDA is a calculation to remove non-recurring, exceptional and one-time items from a company’s EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) to provide a more accurate representation of its underlying EBITDA performance. It is sometimes also referred to as normalized EBITDA.
Adjusted EBITDA is a non-GAAP metric commonly used by financial analysts, investment bankers and investors and is often used when as a proxy for operating cash flow when calculating a company’s enterprise value in the context of fundraising or sale processes.
Adjusted EBITDA vs EBITDA
The standard EBITDA calculation is a financial metric that takes a company’s net income and adjusts it to exclude the effect of interest, taxation, depreciation and amortization.
The reason for calculating EBITDA is to exclude the impact of the company’s financing (by deducting interest paid and adding back interest received), tax strategy (by excluding taxes) and asset depreciation policies to provide a more accurate picture of its earnings.
However, there are often also one-time, non-recurring, exceptional or otherwise unusual income or expenses items recorded in a company’s financial statements that can distort EBITDA. For this reason, additional adjustments may be identified and removed from EBITDA.
While these are often referred to as EBITDA addbacks, in practice these may also be deductions to EBITDA to reflect incorrect or inaccurately-recorded expenses, as well as to remove non-trading income which may be inflating the company’s earnings.
The importance of adjusted EBITDA for valuation
Adjusted EBITDA is an important basis for determining a company’s operating profitability in the context of valuation and M&A transactions.
A company’s adjusted EBITDA is used by valuation experts, finance professionals, investment bankers, lenders and investors to assess performance, including comparing companies to peer companies in the same industry.
Adjusted EBITDA is often used as a basis for computing a valuation multiple range that serves as a key reference point in the context of transactions such as raising capital and setting a purchase price for a potential sale of the business.
Adjustments to EBITDA
EBITDA adjustments can take the form of addbacks or deductions, and some are less well-understood (and identified) than others.
EBITDA addbacks
EBITDA addbacks are adjustments to remove or reduce certain expenses, with the effect of increasing adjusted EBITDA.
Common EBITDA add-backs tend to fall into the following categories:
- One-time expenses, such as one-time legal or consulting fees
- Non-cash expenses, such as stock-based compensation
- Normalization for owner expenses or compensation in excess of market rate
- Unrealized foreign exchange losses
- Correction of non-GAAP accounting inconsistencies and timing differences.
The fun doesn’t stop here, though.
EBITDA deductions
It’s important to understand that when the company’s financial statements have been thoroughly assessed by someone with the necessary experience and a critical eye, EBITDA adjustments may also take the form of deductions, and not just addbacks.
That is, they have the effect of reducing adjusted EBITDA.
Examples of common deductions I make frequently include the removal of one-time, non-cash or non-trading income, such as unrealized foreign exchange losses and one-time government grants (most recently, I’ve adjusted EBITDA to exclude income relating to PPP loans companies received, that are not repayable).
Other deductions may be made to reflect the impact on a company’s run rate profitability of losing a major contract that has not been replaced, or to reflect unrecorded expenses such as the cost of services received below market rate (or even for free) from related parties, or expenses that have simply not yet been captured in the monthly financial statements by a company’s bookkeeper.
Thorough grooming of the company’s detailed monthly financial statements and supplemental information, together with discussions with Management by someone with in-depth knowledge in this area, can often bring to light many additional previously-unidentified EBITDA addbacks.
For example, a $100,000 add-back to EBITDA for out-of-period or non-recurring expenses on a business being valued with an 8x multiple will drive an $800,000 increase in its valuation!
Pro forma EBITDA adjustments
In addition to EBITDA addbacks as described above, there may also be potential pro forma EBITDA adjustments to take into consideration.
I consider this for every company, especially with fast-growth, dynamic businesses that are scaling up their customer base, contracted recurring revenues, acquiring other businesses and taking actions to streamline their fixed cost base and boost the company’s earnings.
If you’ve recently had a significant increase in run rate profitability then it may be appropriate to also recalculate adjusted EBITDA to take these positive changes into consideration and present a more accurate picture of the company’s profitability on a go-forward basis.
A seasoned finance professional such as a fractional CFO with the necessary expertise to review and identify these adjustments as part of helping you prepare your company for an exit can therefore add a tremendous amount of value to the company’s shareholders where the adjusted EBITDA calculation is used as a basis for computing its enterprise value.
Benefits of Calculating Adjusted EBITDA
Accurate financial metrics such as a robust adjusted EBITDA calculation are essential for understanding a clearer picture of the company’s profitability and ensuring the board and the company’s investors are making well-informed decisions.
Calculating adjusted EBITDA and including it in internal financial statements is important for the integrity of the company’s ongoing regular financial reporting and analysis, and essential if you are looking to maximize value in the context of raising funds or undertaking an M&A transaction.
For assistance with preparing your company for a potential transaction, including exit readiness, preparation for a buyer’s financial due diligence or assistance with a contemplated acquisition, get in contact to discuss how I can help.
