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. 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 lossesUnrealized Gains And LossesUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal.
- Legal Expenses
- Impairment of GoodwillImpairment Of GoodwillGoodwill impairment is the process of writing off the accounting charge amounting to the excess of the acquired asset's book value as recorded in the financial statements over its fair value. A higher impairment charge reflects the company's irrational investment decisions.
- Impairment of Assets
- Forex Gains/Losses
How to Calculate Adjusted EBITDA?
Follow the below steps:
- 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.
- Now add all those one-time non-recurring expensesOne-time Non-recurring ExpensesNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.Non-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.Non-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off. 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.
- 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 expensesOne-time Non-recurring ExpensesNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off. 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 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.. Mr. Unreal first calculates EBITDA and then makes necessary adjustments in it to arrive at the adjusted EBITDA figure. As follows:
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. 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 Equivalents. 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. 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
- 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 earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments. 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 to properly value them for potential acquisitions.
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. 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 Sales.
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.
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 –