Understanding Adjusted EBITDA | Marcum LLP
EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a commonly used measure to assess a company’s profitability and ultimately its purchase price.
When calculating a company’s EBITDA, there is often standardization adjustments made for items outside the typical components of EBITDA. The purchase price of a transaction is often based on adjusted EBITDA for the previous 12-month period, multiplied by a multiple of EBITDA (which varies by industry and recent comparable transactions, although always subject to negotiation ).
These adjustments can have a significant impact on the purchase price. For example, if a company’s purchase price is based on a multiple of 10x EBITDA, a normalization adjustment of $100,000 could change the purchase price by $1,000,000.
Whether you are considering a trade as a buyer or a seller, it is important to be aware of common normalization adjustments:
These include one-time expenses that do not recur in the normal course of business. Identifying these expenses is critical because they can skew a company’s historical operating expenses and potentially underestimate EBITDA. Examples of one-time expenses include one-time professional fees, start-up costs, and one-time accounts receivable write-offs.
If a business closes or discontinues a line of products or services, all revenue and expenses related to discontinued operations should be removed from Adjusted EBITDA, as these operations will not continue after closing. If discontinued operations result in an operating loss, this would increase Adjusted EBITDA.
Owner related expenses
Sometimes businesses incur expenses that primarily benefit the owner. These may include the purchase or use of personal property, such as boats or vehicles; family entertainment; tickets to sporting events or club memberships for personal use; or personal life insurance. These owner-related expenses can lead to a significant increase in EBITDA.
Headcount and payroll costs may fluctuate with growth, contraction, or market-driven labor rate changes. Adjustments may be necessary if significant changes have occurred during the due diligence period, such as turnover in the C-suite or other key positions. Additionally, some family businesses may employ family members who do not perform business functions or whose positions may be eliminated after a transaction closes. In these scenarios, an adjustment may be proposed to remove the compensation expense.
Conversion of cash into accrual
If a business operates on a cash basis or modified accrual basis, there may be accrued liabilities missing during the due diligence period. The most common cash adjustments to accrued liabilities relate to payroll, insurance and other major recurring expenses. It is important to identify these missing entries and determine their impact on historical operations.
PPP Debt Forgiveness
In 2020 and 2021, the Cares Act provided businesses with forgivable loans to encourage employee retention during the COVID-19 pandemic. The companies kept the loan on their balance sheets until they received a rebate from the SBA. Income recorded on the loan is considered non-recurring and should be included as a normalization adjustment.
Non-cash expenses are common normalizing adjustments. Examples include stock-based compensation, gains or losses on currency translations, and changes in insurance cash value.
Related party transactions
Many companies have related party agreements. Common examples include leasing assets from related parties, purchasing goods from a related supplier, or entering into other transactions with companies that share common or related ownership. If these transactions are not at market value, EBITDA may need to be adjusted to reflect what the expense would have been with an independent party.
Understanding a company’s Adjusted EBITDA is key to determining its profitability and setting a purchase price. Business owners and management should carefully monitor any potential adjustments in order to be ready for a transaction.
Marcum’s transaction professionals can help you identify adjustments based on the facts and circumstances of your business.