5 adjustments to consider when calculating normalized EBITDA
Business owners use myriad metrics to evaluate their performance. Buyers and third parties, however, tend to focus on one figure more than others: earnings before interest, taxes, depreciation and amortization (EBITDA).
EBITDA is not impacted by the equity structure of a business, so it’s a neutral guide as to whether a company is funded with debt or equity and able to generate cash.
All companies, and especially those contemplating a transaction in the next one to three years, should actively track and manage EBIDTA. When tracking, companies need to consider whether their EBITDA computation would be the same if the business were owned by a third party. To calculate that, it’s often necessary to adjust (or normalize) the computation.
These are the top five adjustments that closely held businesses need to consider to calculate normalized EBITDA:
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 Wipfli can help
Normalized EBITDA is an important metric that should be assessed diligently and annually.Contact Wipfli to learn more normalized EBITDA and other tax strategies to protect and increase the value of your business.
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