Adjusted EBITDA

What is Adjusted EBITDA?

Adjusted EBITDA is the measurement of company’s recurring earnings before deducting interest expense, tax expense, depreciation & amortization expenses and further adjusting extraordinary items which are non-recurring in nature are adjusted from the amount of EBIDTA like legal expenses, gain/loss on the sale of a capital asset, impairment of assets, etc.

It is a valuable financial metric that arises after removing one time and nonrecurring items from EBITDA (earnings before interest, taxes, depreciation, and amortization). It is also referred to as Normalized EBITDA. Normalization is a process of systematizing cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more and removing anomalies or deviations from a financial metric, say standard EBITDA. Public companies are required to report only the figures of standard EBITDA under GAAP rules. This amount has to be separately calculated for valuation and analytical purposes.

Adjusted EBITDA Formula

Adjusted EBITDA = EBITDA +/- Adjustments
Adjusted EBITDA

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For eg:
Source: Adjusted EBITDA (wallstreetmojo.com)

Where EBITDA = Net Income + Interest + Taxes + Depreciation and Amortization

List of Items excluded in Adjusted EBITDA

How to Calculate Adjusted EBITDA?

Example of Adjusted EBITDA

ABC investments advisory give a task to Mr. Unreal to find the adjusted EBIT of Banana Inc for the previous year and provide the data of the income statement of the companyIncome Statement Of The CompanyThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. Mr. Unreal first calculates EBITDA and then makes necessary adjustments in it to arrive at the adjusted EBITDA figure. As follows:

adjusted EBITDA example 1
adjusted EBITDA example 1.1

Importance

EBITDA is an important valuation tool because it is used as a proxy for operating cash flowsOperating Cash FlowsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more to calculate the enterprise value of the company. However, adjustments to EBITDA should not be overlooked as it can have a significant impact on business valuation. E.g., from the above example, after calculating EBITDA and adjusted EBITDA, Mr. Unreal is further given a task to calculate the enterprise valueCalculate The Enterprise ValueThe Enterprise Value Formula is an economic measure that reflects the entire value of the organization, including secured and unsecured creditors, equity and preference shareholders, and is more commonly employed in acquiring other businesses or merging two or more businesses to achieve synergy. Enterprise value Formula = Market Capitalization + Preferred stock + Outstanding Debt + Minority Interest – Cash & Cash Equivalentsread more. An industry multiple of 5-times has been provided.

Enterprise value = EBITDA * Multiple

The enterprise valueEnterprise ValueEnterprise Value is a measure of a company's total value that spans the entire market rather than just the equity value. It includes all debt and equity-based ownership claims. This value, which is calculated as the market value of debt + market value of equity - cash and cash equivalents, is particularly relevant when valuing a takeover.read more with given multiple of 5 becomes $ 22,750,000 for EBITDA of $ 4,550,000. Now let’s calculate the enterprise value using the adjusted EBITDA of $ 5,650,000. We get Enterprise value of $ 28,250,000 ($ 5,650,000 * 5).

The enterprise value of Banana Inc boosted by a tremendous amount of $ 5,500,000 ($ 28,250,000 – $ 22,750,000). Hence Mr. Unreal must consider the adjusted EBITDA while calculating the value of the business.

Note: Adjustments made to EBITDA generally are one-time expenses that are not going to incur soon or after business gets sold. Thus such expenses must be true and fair because the management of the buying company strictly scrutinizes these.

Adjustments to EBITDA and its Impact on Enterprise Value

  • Excess Owner Salaries: If the salary of the owner, including bonuses and commissions, is $ 500,000 per annum but the market rate to replace the owner is $ 350,000. i.e., the owner is taking an excess salary of $ 150,000. It can be charged as an adjustment. The value of enterprise increased by $ 750,000, considering industry multiple of 5 times. i.e. $ (500,000 – 350,000) * 5
  • Litigation Expenses: Litigation expenses in the form of a lawsuit settlement, legal and consultancy fees are all nonrecurring expenses and can be charged as legitimate adjustments.
  • Disposal of Assets: Assets are not meant to be sold. However, there are situations like technology upgrades, lower performance of existing assets, etc. These are one-time, nonrecurring expenses or gains that can be positively or negatively adjusted as a legitimate adjustment. E.g., the number of profits for the property sold must be deducted from EBITDA while the number of losses on sales of some old machinery can be added to EBITDA as legitimate adjustments.
  • Rent of the facilities: If the rent charges are above fair market value, then the difference would be negative. Rent profits must be deducted as negative adjustments vice-versa for the opposite situation.

Advantages and Applications

Disadvantages

The rules of GAAPRules Of GAAPGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.read more do not apply to adjusted EBITDA values. The companies thus can manipulate these EBITDA figures and publish the misleading values by adding a variety of unnecessary expenses, to artificially inflate margins and distract the investor from ugly looking net income figures.

Thus investors and analysts should properly scrutinize the adjustments. Remember, the EBITDA margins of a company will always remain higher than its Net profit margin, and the Adjusted EBITDA margins are generally higher than its standard EBITDA marginsEBITDA MarginsEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company's operating profitability and cash flow position. It is calculated by dividing the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Salesread more.

Conclusion

Adjusted EBITDA normalizes the EBITDA value that represents the financial health of the company more accurately. It is mainly used to value the enterprise during mergers and acquisitions. The adjustments can inflate the value of the company, sometimes dramatically. But adjustments must be made with full care and due diligence so the buyer can accept those adjustments to be fair and legitimate.

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This article has been a guide to what is Adjusted EBITDA. Here we discuss how to calculate Adjusted EBITDA using its formula along with practical examples & explanation. We also discussed its advantages and disadvantages. You can learn more about financing from the following articles –

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