When it comes to selling your business, it’s crucial to understand the most important EBITDA adjustments that can significantly impact the outcome. In this article, we will explore the top 10 EBITDA adjustments you should consider to enhance the value of your business during the sales process.

By normalizing your EBITDA and presenting a compelling financial performance, you can attract potential buyers and secure the highest possible price for your company.

Why Normalize EBITDA?

EBITDA is commonly used as a measure of operating cash flow and plays a vital role in valuing companies. While it can be interpreted in various ways, EBITDA often sets the foundation for determining a company’s worth by applying a multiple, such as the 5x TTM EBITDA.

Consequently, normalizing EBITDA to present the most accurate and favorable financial representation becomes essential. Savvy buyers, however, look beyond EBITDA and focus on free cash flow to evaluate a business comprehensively, considering factors like capital expenditures, interest, and taxes.

Nevertheless, knowing how to normalize EBITDA and showcase an impressive figure remains a valuable skill for business owners.

How to Calculate EBITDA

EBITDA, short for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a widely used metric in the financial world. It gained popularity during the leveraged buyout frenzy of the 1980s and has since become ubiquitous in financial circles.

EBITDA serves multiple purposes, including business valuation, company comparison, and loan covenant establishment. While seemingly straightforward, it is important to handle this “non-GAAP” measure with care.

Understanding the Calculation of EBITDA

The calculation of EBITDA varies depending on the starting point. However, in general, EBITDA can be calculated using the following formulas:

EBITDA = Operating Profit + Depreciation + Amortization

EBITDA = Net Income + Interest + Taxes + Depreciation Expense + Amortization

Let’s dive deeper into the definitions of the individual terms:

1. Net Income: This represents the revenue remaining after deducting all expenses, such as costs of goods sold, SG&A, depreciation, amortization, financing costs, and taxes.
2. Operating Profit: It denotes the profit earned from operations, obtained by subtracting expenses like costs of goods sold, SG&A, depreciation, and amortization from revenue.
3. Interest: This refers to financing costs incurred on outstanding debt.
4. Taxes: It indicates the income tax expense for a specific period.
5. Depreciation: It represents the non-cash expense associated with the portion of a tangible fixed asset, such as a building or equipment, considered consumed during the current period.
6. Amortization: This refers to a non-cash expense similar to depreciation but specifically applicable to intangible assets. Examples of intangible assets include patents, trademarks, copyrights, and goodwill.

Exploring the Significance of EBITDA

EBITDA finds applications in various ratios and calculations. One of the useful metrics derived from EBITDA is the EBITDA Margin, which represents EBITDA as a percentage of revenue. This metric provides insights into the amount of operating cash generated for every dollar of revenue earned.

EBITDA Margin is commonly used to compare companies within the same industry. A higher EBITDA margin is generally considered more favorable than a lower one, indicating better operational efficiency.

Tracing the History of EBITDA

The birth of EBITDA can be attributed to the necessity-driven innovations of the past. In the 1970s, John Malone, a prominent cable billionaire, recognized the importance of scaling operations to control programming costs in the cable business. However, he faced a challenge and an opportunity simultaneously.

During that era, Wall Street and many cable operators primarily focused on net income and earnings per share (EPS) growth. Malone’s growth strategy, which involved maximizing pretax cash flow to fund organic growth and acquisitions, did not align with EPS growth as it required minimizing reported earnings and taxes. To bridge this gap, he leveraged EBITDA to emphasize cash flow to lenders and investors.

EBITDA proved advantageous for heavily leveraged and capital-intensive companies, presenting a more favorable profitability outlook compared to operating profit or net income. By adjusting net income through a series of modifications, EBITDA provided a measure of operating performance that was considered less influenced by specific accounting or financial strategies. This spotlight on operating performance suited certain types of business structures.

The popularity of EBITDA as a value measure continued to grow throughout the 1980s and beyond. In the 1980s, investors involved in leveraged buyouts utilized EBITDA to assess the profitability of distressed businesses and evaluate their capacity to cover restructuring-related financing costs. During the dot-com era, EBITDA served as a favored metric for identifying companies poised for growth but constrained by substantial debt burdens.

Practical Applications of EBITDA Today

In the present day, EBITDA remains a valuable tool for evaluating a company’s operating performance, trusted by business owners, investors, and lenders alike.

Business Owners and Managers: EBITDA enables business owners and managers to compare their company’s operating performance against competitors and industry benchmarks. A strong EBITDA can enhance the prospects of securing business loans as it demonstrates the ability to service debt. Additionally, a high EBITDA margin can attract potential buyers, signaling healthy cash flow and profitability.

Investors: Investors utilize EBITDA as a quick metric to assess a company’s operations, compare it to other investments within the same industry, and gauge its valuation. If a target company exhibits strong EBITDA but weak net profits, it might be an attractive acquisition opportunity if the investor can strategically restructure the target’s assets and debt.

Lenders: Lenders rely on EBITDA to assess a borrower’s operating performance in relation to competitors. It also offers insights into the cash position, with the underlying logic that healthy EBITDA translates into robust operating cash flow. Furthermore, EBITDA provides an indication of the borrower’s ability to repay loans. Lastly, EBITDA frequently forms the basis for debt covenant agreements.

Analyzing the Advantages and Disadvantages

While EBITDA is a widely used measure, it is crucial to understand its strengths and weaknesses to avoid misleading interpretations of a company’s financial situation.

Advantages of EBITDA:

1. Easier Calculation: EBITDA can be easily calculated using information from the income statement.
2. Focus on Operating Performance: By excluding the impact of accounting, tax, and financing decisions, EBITDA sheds light on operating performance. Variables such as depreciation, amortization, tax, and interest, which can differ between companies, do not affect operating performance. Interest varies based on capital structure, while tax expenses differ by jurisdiction and are not directly tied to a company’s operations. Depreciation and amortization, being non-cash expenses, are subjective and do not directly impact operations.
3. Comparability: EBITDA facilitates company comparisons against competitors and industry averages.

Disadvantages of EBITDA:

1. Non-GAAP Measure: EBITDA is a non-GAAP measure, which means its calculation may not be consistent across different companies and can potentially be manipulated.
2. Not a Substitute for Cash Flow: EBITDA does not incorporate changes in working capital and capital expenditures, making it an incomplete substitute for cash flow analysis.
3. Potential Distractions: EBITDA can favor companies with high taxes, interest expenses, and depreciation/amortization. This focus on profitability may divert attention from poor management decisions, such as taking on high-interest debt or neglecting the replacement of aging equipment.
4. Ignores Asset Costs: EBITDA overlooks the cost of assets and assumes that profitability is solely a result of sales and operations.

Top 10 EBITDA Adjustments

To optimize your EBITDA, it is crucial to implement certain adjustments before listing your business for sale. Here are the top 10 normalizing adjustments you should consider:

1. Non-Arms-Length Revenue or Expenses

This adjustment refers to transactions between your company and related parties conducted at prices above or below market rates. For instance, if your operating company purchases supplies from another company owned by a major shareholder at prices higher than their fair market value, your EBITDA should be normalized accordingly to reflect the accurate value of these supplies.

2. Revenue or Expenses Generated by Redundant Assets

Redundant assets are assets that are not essential for running the business effectively. For example, if your business owns a lake cottage occasionally used for company functions or employee incentives, the expenses related to the cottage should be added back to normalize EBITDA since it is considered redundant to potential buyers.

3. Owner Salaries and Bonuses

Owner salaries and bonuses often differ from regular salaries paid to third-party managers. Additionally, owners may declare year-end bonuses to reduce income taxes. To calculate recurring EBITDA, these extraordinary owner salaries and bonuses need to be added back, while an estimated compensation for a third-party manager should be deducted.

This adjustment typically results in an increase in EBITDA, particularly if substantial year-end owner bonuses have been paid.

4. Rent of Facilities at Prices Above or Below Fair Market Value

Many companies lease facilities from a holding company owned by a shareholder, and the rent charged is often set arbitrarily higher than the market rate. Similar to related-party transactions, this adjustment involves adding back the non-arms-length rent and subtracting the true market rent to adjust EBITDA upward.

5. Start-Up Costs

If your business has launched a new product line or service during the period under analysis, the associated start-up costs should be added back to EBITDA. Since these costs are one-time expenses and will not recur in the future, excluding them provides a more accurate representation of the business’s ongoing financial performance.

6. Lawsuits, Arbitrations, Insurance Claim Recoveries, and One-Time Disputes

Extraordinary income or expenses resulting from settled legal matters or one-time disputes should be adjusted in EBITDA. Income such as insurance claim recoveries would be deducted, while expenses like lawsuit settlements would be added back. These items are considered non-recurring and should not impact the ongoing financial performance of the business.

7. One-Time Professional Fees

Expenses related to matters that do not recur in the future, such as legal fees for settling a dispute or accounting fees for special transactions, should be added back to EBITDA. By excluding these one-time professional fees, you present a clearer picture of the business’s regular financial performance.

8. Repairs and Maintenance

Often overlooked, repairs and maintenance expenses play a significant role in EBITDA adjustments. Some private business owners intentionally categorize capital expenses as repairs to minimize taxes. While this practice may lower annual tax obligations, it can negatively impact the valuation of the business during a sale by reducing historical EBITDA.

To ensure an accurate representation, a thorough review should be conducted to separate capital items from repairs and add back any capital expenses to EBITDA.

9. Inventories

If your company utilizes equipment to provide services, it is common to have parts inventory on hand. Private business owners often maintain a general allowance for parts inventory throughout the year, expensing parts acquired during that period to minimize taxable income.

However, as you approach the sale of your business, it is recommended to conduct a close inventory count and valuation. Any excess inventory beyond the carried allowance should be added back to EBITDA to accurately reflect the actual inventory value.

10. Other Income and Expenses

The “Other Income and Expenses” category in financial statements often includes items that can be adjusted in EBITDA calculations. This category tends to be a catch-all for various expenses that do not fit into specific codes. It is crucial to review these accounts carefully and add back any non-recurring items. For example, one-time employee bonuses or special donation expenses recorded under this category should be added back to EBITDA.

The Power of Normalized EBITDA

Numbers are not always black and white, especially when it comes to calculating EBITDA for the purpose of selling your business. Investment bankers rely on a five-year summary of normalized EBITDA to market your company effectively.

By proactively reviewing your numbers well in advance of the sale, you can ensure that you secure the best deal possible. Remember, an EBITDA that is five times higher will always be more advantageous. Embrace the power of normalized EBITDA to maximize the value of your business during the sales process and attract potential buyers with confidence.