Adjusted EBITDA: What is it and how is it calculated?
- Adjusted EBITDA is a variation on EBITDA that attempts to create a clearer measure of a business’s overall financial health by accounting for additional elements not considered in the standard EBITDA formula.
- Use adjusted EBITDA to help you more accurately understand the value of a business as part of a merger, acquisition, sale or other transaction.
- Be aware that adjusted EBITDA is a non-GAAP accounting measure, which means there is no standard list of adjustments, although it typically includes elements like owner compensation and expenses, non-recurring revenues or expenses and related party transactions.
If you’re contemplating a transaction, you’ll probably lean heavily on earnings before interest, taxes, depreciation and amortization (EBITDA) to get a sense of a business’s financial health and determine valuation. But relying on EBITDA alone can leave you blind to the fact that two companies with similar EBITDAs have dramatically different finances.
That’s why buyers, sellers and investors often turn to adjusted EBITDA to clarify a business’s true value. Keep reading to learn more about what adjusted EBITDA is, when to use it and how to calculate it.
What is adjusted EBITDA?
Adjusted EBITDA (or normalized EBITDA) is an accounting measure designed to make it easier to compare the EBITDA of different companies against one another. It essentially normalizes a company’s EBITDA by accounting for certain additional elements like nonrecurring revenues or expenses, non-cash expenses or even personal expenses incurred by the company’s owner.
This often makes adjusted EBITDA a more accurate barometer by which to measure a company’s overall financial state and value than standard EBITDA. For example, two companies with different levels of debt may have the same standard EBITDA, but notably different adjusted EBITDAs.
However, EBITDA adjustments can also be used to hide financial problems or red flags.
EBITDA versus adjusted EBITDA
EBITDA helps investors, lenders, buyers and sellers to establish a picture of a company’s financial health. Adjusted EBITDA just takes this a step further by adding in additional factors that could significantly impact the profitability or value of a business, but are not included in the standard EBITDA formula.
Why EBITDA matters for business owners
EBITDA and adjusted EBITDA are both useful tools if you are planning to buy or sell a business. EBITDA helps you determine an appropriate valuation, and adjusted EBITDA allows both buyers and sellers to get a sense of how a particular business stacks up against competitors, peers or industry averages.
When should businesses use adjusted EBITDA?
Businesses should use adjusted EBITDA when preparing for a transaction like a merger, acquisition, sale, investment or loan. All parties to a transaction may want to take adjusted EBITDA into account when discussing terms, establishing a valuation or assessing the stability of a company’s finances.
Adjusted EBITDA can also help CFOs and other leaders make smarter strategic decisions based on a clearer understanding of a business’s financial standing.
List of common EBITDA adjustments
Accountants may choose to include any relevant adjustments when calculating adjusted EBITDA. Here are five top adjustments that closely held businesses need to consider:
1. Owner and executive compensation
In a closely held business, owner compensation may be set lower or higher than the company would pay an unrelated third-party executive. It’s not unusual for a business to pay the owner what it can afford versus a market-rate salary.As a result, the amount paid compared to the market rate should be determined annually and accounted for in a normalized EBITDA calculation.
2. Renting or leasing vs. owning equipment and facilities
Equipment rental or lease agreements may be accounted for as operating leases (i.e., generated rent expense) or capital leases (i.e., generated principal, interest and depreciation) under rules applied by generally accepted accounting principles. Operating leases reduce both net income and EBITDA, while interest and depreciation associated with capital leases are added back to net income for EBITDA. Both situations are important to consider if there is a potential sale of the business.
3. Unusual and nonrecurring revenues or expenses
It’s easier to identify unusual and nonrecurring items of revenue or expense when they occur, versus trying to remember what they were.As such, consideration should be given to any unusual, nonrecurring or nonoperating revenues or expenses that impact the computation of normalized EBITDA on an annual basis.Some examples of nonrecurring items are legal fees related to a contract negotiation or lawsuit, start-up costs and unusual consulting costs.
4. Related party transactions
Are there any transactions with related parties, below or above market rates, for similar goods and services that would be acquired from a third party? This kind of transaction is common when a company rents space from a related party.Often, the rent being paid is based on what the business can afford instead of market rates (similar to owner compensation), resulting in above-market rent and lower EBITDA.
5. Other operating expenses
Operations should be reviewed to determine if there are expenses a third party would consider unnecessary or excessive. For example, businesses often entertain clients, and the level and cost of that entertainment can vary widely from one business owner to another.These types of discretionary expenses should be reviewed to determine if an adjustment is needed to normalize EBITDA
How to calculate adjusted EBITDA
To calculate adjusted EBITDA, take a business’s EBITDA and then add or subtract any relevant adjustments. Because you will only include adjustments relevant to your business or a business you are valuing when calculating adjusted EBITDA, there is no single standard formula for which adjustments get used (in accounting terms, adjusted EBITDA is a non-GAAP metric).
However, adjusted EBITDA commonly includes adjustments like those discussed in the previous section.
Common mistakes when calculating adjusted EBITDA
When calculating or considering adjusted EBITDA, be aware that because there is no set list of adjustments to be included, different people could calculate it differently. If you are using adjusted EBITDA to evaluate a business as part of a transaction, be sure to understand what adjustments were included in determining the figure, and don’t rely on adjusted EBITDA alone to make a decision.
You should also be aware that in certain cases, adjustments can be included in an adjusted EBITDA calculation to distort a business’s finances and hide problems or red flags.
How Wipfli can help
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