Adjusted EBITDA Explained

What is EBITDA?

EBITDA is a performance metric used to compare the true profitability of companies. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is calculated based on a company's net income. This net income has already accounted for interest, taxes, depreciation, and amortization (ITDA). In order to get to the EBITDA, the factors must be added back to the net income. For example, the depreciation expense would be added back to the net income to counter the initial expense used to calculate net income.

• Interest – Interest is calculated in EBITDA because a new owner may decide to invest or take on debt differently than current ownership. This decision could result in more or less interest, which is why it is added back to the EBITDA calculation.
• Taxes – Taxes are like interest, similar to how a new owner could decide to change the business structure and how the company is currently taxed to better fit the needs of the future situation.
• Depreciation – Depreciation is added back to EBITA because new ownership may utilize a different depreciation schedule than current ownership and may carry different assets in general.
• Amortization – Amortization is treated the same way as depreciation, except instead of fixed assets, which covers intangible assets that the company owns, carries, or holds.

Why is EBITDA used?

EBITDA is used to even the playing field in mergers and acquisitions. It is a metric used to normalize businesses on the market to the same equal standard. Running a business is complicated, and multiple decisions affect a company's bottom line. EBITDA is used to remove these decisions and find an interpretable bottom line.

What is Adjusted EBITDA?

Adjusted EBITDA takes the normalization one step further by removing ALL items from a company's profit and loss statement that will likely not occur post-sale under new ownership. These items are added back because they are usually non-operational expenses or income, meaning that a new owner cannot count on them to continue post-sale. The ITDA is commonly used and straightforward in the calculation of EBITDA. Unlike the ITDA, adjustments are sometimes up for interpretation as it can be unclear if something will continue post-sale.

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Common Adjustments to EBITDA

1. Owner's compensation – Often, the owner's compensation is a great starting point for the first adjustment. Owner's compensation must align with the current ownership's goals and exit plan. If ownership plans to exit, the best practice would be to add back the total salary, less any required salary, to replace the owner's current role. The current owner's salary minus the expected post-sale salary would be the appropriate calculation for this adjustment to EBITDA. It is also possible that ownership will stay and expect a raise post-sale; this would require a negative adjustment to reflect the difference in current and post-sale salary. An important note to remember is that we are adjusting to the expectation of how the company will run post-sale.
2. Owner's expenses – Similar to owner's compensation, owner's expenses are personal to ownership and must be added back to the EBITDA as they will not continue post-sale. An owner's common expenses include automobile, cell phone, credit card payments, home improvement, etc.
3. Rent – Adjusting for rent is also subject to post-sale plans. If a related entity does not own the operating facility and rent would continue post-sale, an adjustment may not be needed. However, if current ownership owns the property that the company operates from and plans to include it in the sale, then the company would need to add any rent to current ownership or holding company paid in previous years.
4. COVID Relief Funding – COVID funding is always added back to the EBITDA as, hopefully, this relief funding will not be necessary again. By nature, this was a one-time experience to support businesses, and therefore, we must normalize it to meet the standard established in other years. COVID relief funding is always added back in full and can include PPP loans, EIDL loans & grants, municipal grants, and others.
5. Family compensation – Family compensation is also added back, as in most deals, any historical payments made to a family member who is not an employee of the company would need to be added back. However, if a family member is an employee, the salary would not require an adjustment unless they plan to exit at the time of sale.

Improving EBITDA

Sometimes, as a company prepares to enter the market, it may realize its EBITDA is lower than expected. Instead of taking that news and moving on, here are some ways to improve EBITDA. Reducing costs is an excellent way to increase EBITDA as this will increase net income, which is EBITDA's starting point. Increasing automation at the company and keeping processes easy and efficient is a great way to lower costs and increase EBITDA. Increasing revenue will also increase your EBITDA if your expenses remain the same. Service contracts or other long-term agreements with customers can help secure recurring revenue and allow the company to utilize fewer resources on customer retention throughout the contract's life.

Summary

Adjusted EBITDA is a calculation based on all the above factors. It is used when finding the actual value of companies and completing M&A transactions by normalizing the selling company to a common ground. Adjusted EBITDA makes it easy for buyers to compare their options in the M&A market and decide how they would like to move forward based on the company's accurate financial picture. Of course, as stated above, adjustments are subject to the buyer's discretion. They can be challenged, so adjustments need to reasonably represent the expected activity of the company post-sale.

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