September 27, 2022

Understanding Adjusted EBITDA

By Amy Gardi, Supervisor, Transaction Advisory Services

Understanding Adjusted EBITDA Transaction Advisory

EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is a metric commonly used to assess a company’s profitability and ultimately its purchase price.

When calculating a company’s EBITDA, there are often normalizing adjustments made for items outside of EBITDA’s typical components. A transaction purchase price is often based on an adjusted EBITDA for the preceding trailing 12-month period, multiplied by an EBITDA multiple (which varies by industry and recent comparable transactions, although still subject to negotiation).

These adjustments can significantly impact the purchase price. For instance, if a company’s purchase price is based on a 10x EBITDA multiple, a $100,000 normalizing adjustment could change the purchase price by $1,000,000.

Whether you’re considering a transaction as a buyer or a seller, it is important to be aware of common normalizing adjustments:

Non-recurring expenses

These include one-time expenses that do not recur during the normal course of business. Identifying these expenses is critical because they can distort a company’s historical operating expenses and potentially understate EBITDA. Examples of non-recurring expenses include one-time professional fees, start-up costs, and non-recurring account receivable write-offs.

Discontinued operations

If a business closes or discontinues a product or service line, all revenues and expenses related to discontinued operations should be removed from adjusted EBITDA because these activities will not continue post-close. If the discontinued operations cause an operating loss, it would increase adjusted EBITDA.

Owner-related expenses

Sometimes businesses incur expenses that are primarily for the benefit of the owner. These can include the purchase or use of personal assets, such as boats or vehicles; family entertainment; sporting tickets or club memberships for personal use; or personal life insurance. These owner-related expenses may lead to a significant EBITDA add-back.

Payroll adjustments

Headcount and payroll expenses can fluctuate based on a company’s growth, contraction, or market-driven labor rate changes. Adjustments may be needed if significant changes occurred during the due diligence period, such as turnover in the C-suite or in other key positions. Additionally, some family-owned businesses may employ family members who do not perform business functions, or whose position may be eliminated following the close of a transaction. In these scenarios, an adjustment may be proposed to remove the compensation expense.

Cash-to-accrual conversion

If a company operates on a cash or modified accrual basis, there could be missing accrued expenses during the due diligence period. The most common cash-to-accrual adjustments are for payroll, insurance, and other large recurring expenses. It is important to identify these missing entries and determine their impact on historical operations.

PPP debt forgiveness

During 2020 and 2021, the Cares Act provided businesses with forgivable loans to encourage employee retention during the COVID-19 pandemic. Companies held the loan on their balance sheets until they received forgiveness from the SBA. The income recorded from the loan is considered non-recurring and should be included as a normalizing adjustment.

Non-cash expenses

Non-cash expenses are common normalizing adjustments. Examples include stock-based compensation, gains or losses on foreign exchange translations, and changes in insurance cash surrender value.

Related party transactions

Many companies have agreements with related parties. Common examples include leasing assets from related parties, purchasing goods from a related supplier, or conducting other transactions with companies that share common or related ownership. If these transactions are not at market value, EBITDA may have to be adjusted to reflect what the expense would have been with an independent party.

Understanding a company’s adjusted EBITDA is critical to determining its profitability and setting a purchase price. A company’s owners and management should carefully track any potential adjustments to be ready for a transaction.

Marcum transaction professionals can assist in identifying adjustments based on your company’s facts and circumstances.