The BizQuest Team Published July 12, 2023
Adjusted EBITDA: What Are Add-Backs to EBITDA?
The BizQuest Team
For business owners, gauging the true financial health of a company, especially when evaluating its cash flow, is pivotal. One metric that has become increasingly indispensable for financial analysts, investment bankers, and sellers is adjusted EBITDA. In the domain of business financial statements and GAAP (generally accepted accounting principles), understanding adjusted EBITDA and its nuances provides clarity, paving the way for transparent, successful transactions, especially during mergers or restructuring phases.
What Is EBITDA?
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a fundamental element on a company's income statement. It provides a snapshot of the company's profitability by removing potential distortions resulting from different tax variations, interest expense related to debt, or non-cash items on the balance sheet, such as depreciation and amortization.
How Is It Calculated?
At its heart, EBITDA zeroes in on a company's earnings before deducting interest, taxes, depreciation, and amortization. It's a simple formula:
While it might appear straightforward, this metric holds considerable weight in the financial realm, often acting as the baseline for further analyses.
When to Use SDE vs EBITDA?
Both SDE (Seller's Discretionary Earnings) and EBITDA are vital metrics outlined in Excel templates used by financial experts. SDE, which accounts for the business owner's compensation, might be more relevant for startups or smaller businesses. EBITDA, conversely, is better suited for mid-sized to large entities, emphasizing operating income and operational profitability. The choice depends on the business size and the role of the business owner.
What Is Adjusted EBITDA?
Adjusted EBITDA refines the standard EBITDA by considering non-recurring items and EBITDA adjustments, offering a clearer view of a company's sustained profitability. Adjusted EBITDA provides insights beyond the top-line numbers by accounting for various non-operating and one-time expenses, like litigation expenses or stock-based compensation. It becomes an invaluable tool for sellers, investors, and due diligence processes, serving as a basis for business valuation.
Exploring Valid Add-Backs to EBITDA
Excess Owner’s Salary: When an owner pays themselves a salary above the market average for similar roles in the industry, this excess amount can be added back to the EBITDA. It ensures the calculation is not skewed by personal compensation preferences, reflecting a more standardized earning capacity.
Owner’s Discretionary Expenses: Personal expenses or discretionary spending that do not contribute to business operations or revenue generation are added back. This adjustment ensures that personal financial choices do not distort the view of business profitability.
One-Time Expenses: Costs that are non-recurring and not related to the regular business operations, such as the severance package for an employee that’s laid off. Removing these from the calculation provides a clearer view of the ongoing financial health of the business.
Moving or Remodeling Expenses: Costs incurred for relocating or refurbishing the business premises, which are not recurring expenses. Ensures that investments in infrastructure improvements do not unfairly depress the earnings representation.
Non-Recurring Consultant Fees: If a business hires a consultant for a one-time project, these fees are added back. This provides a more consistent view of operational expenses without the distortion of unusual, one-off expenditures.
Below Market Rent Payments: Businesses that pay themselves too little rent, will have to adjust the rent to a market rate, reducing EBITDA.
These add-backs are crucial to providing a more precise and comprehensive view of a company’s adjusted EBITDA. Properly accounting for these elements ensures that the metric more accurately reflects the business’s ongoing operational profitability, making it a more reliable tool for analysis and valuation in the sale process. This granular view is essential for sellers to position their business optimally and for buyers to make informed investment decisions.
Items that Cannot be Added Back
While adjusted EBITDA offers flexibility in considering certain one-off or discretionary expenses to provide a clearer picture of a business's earnings, it's equally vital to recognize the boundaries of these adjustments. Not all expenses or reductions can be added back to EBITDA. Overextending adjustments can distort the business’s true financial position and sustainability, leading to potential miscalculations in its valuation. Here's a closer look at some items that typically don't qualify for adjustments:
Normalized Market Salaries: The compensation paid to employees, including management, should reflect the market rate for their positions and responsibilities. If an owner or executive's salary is adjusted to match industry norms, it can't be added back. Ensuring salaries align with market standards prevents inflating EBITDA based on salary underpayments or cost savings that are unsustainable in the long run.
Standard Operational Expenses: These are the recurring costs directly linked to the day-to-day functioning of the business, such as utilities, rent, and regular maintenance. Such expenses are fundamental to running the business and thus aren't adjusted. Operational expenses give a realistic representation of the company's ongoing overhead. Removing or adjusting these can misrepresent the company's actual operating margins and financial health.
Routine Business Investments: Regular investments made to sustain or grow the business, such as equipment upgrades, staff training, or marketing campaigns, should not be added back. These expenses are essential for business continuity and competitiveness. Reflecting the genuine cost of maintaining and expanding the business ensures that potential buyers or investors get an accurate view of the funds required to keep the business operational and competitive.
While adjusted EBITDA is a valuable tool, it's important to approach its calculation with integrity and discernment. Properly distinguishing between valid add-backs and non-qualifying items ensures that this financial metric remains a robust, transparent, and reliable measure of a company's true earnings potential.
Using a Business Broker or M&A Advisor for Valuation
The terrain of adjusted EBITDA can be complex. Business brokers or M&A advisors, armed with experience and industry insights, can prove indispensable. Their expertise ensures accurate calculations and a valuation that's both fair and market-ready.
Navigating the world of adjusted EBITDA is like piecing together a financial jigsaw puzzle. Each add-back and adjustment, forms a piece of the broader business landscape. For sellers on platforms like BizQuest, an in-depth understanding of these metrics isn't just recommended—it's essential. And as transactions in the under $5MM market gain traction, the quest for clarity in valuation becomes all the more pivotal. With its nuances and intricacies, adjusted EBITDA stands tall as a beacon of financial transparency.
BizQuest has a variety of valuation tools and resources to help buyers, sellers, and owners determine the value of a business:
