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 flows 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
Where EBITDA = Net Income + Interest + Taxes + Depreciation and Amortization
List of Items excluded in Adjusted EBITDA
- Non-Operating Revenue
- One time gain or sale of Property, business etc
- Restructuring and Reorganization charges
- Unrealized gains and losses
- Legal Expenses
- Impairment of Goodwill
- Impairment of Assets
- Forex Gains/Losses
How to Calculate Adjusted EBITDA?
- Step1: Calculate standard EBITDA first, using the net income from the company’s income statement. Net income includes expenses of interest, taxation and depreciation & amortization. Add back all these expenses to the net income figure to get EBITDA value.
- Step2: Now add all those one-time non-recurring expenses that do not occur regularly like Excess owner’s salary, litigation expenses, special donations, etc. Also, add all those expenses which are unique to the company and usually do not incur by peer companies.
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 company. Mr. Unreal first calculates EBITDA and then makes necessary adjustments in it to arrive at adjusted EBITDA figure. As follows:
Importance
EBITDA is an important valuation tool because it is used as a proxy for operating cash flows in order 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 value. An industry multiple of 5-times has been provided.
Enterprise value = EBITDA * Multiple
The enterprise value 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 in near future or after business gets sold. Thus such expenses must be true and fair because these are strictly scrutinized by the management of buying company.
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. This 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, but situations like technology upgrade, lower performance of existing assets, etc 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 rent charges are above fair market value, then the difference would be negative and rent profits must be deducted as negative adjustments. Vice-versa for the opposite situation.
Advantages and Applications
- It removes nonrecurring items and anomalies that distorts EBITDA
- It can be used to evaluate the overall income of a company and determine the annual cash generation by a company.
- It usually required when a company is being valued for acquisitions and mergers (M&A)
- It can more accurately represent a company’s future earnings capacity that an investor would expect.
- It can be used to make easy and meaningful comparison across various companies since different companies’ charges various expenses that are unique in nature or do not incur by companies with similar businesses.
- Adjusted EBITDA is used for analyzing companies in order to properly value them for potential acquisitions.
Disadvantages
The rules of GAAP 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, in order 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 margins.
Conclusion
Adjusted EBITDA normalizes the EBITDA value that represents the financial health of the company more accurately. This 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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