As a business owner, you should always understand the value of your business. It allows you to make more informed and strategic decisions in the short term. These short-term decisions can add up and eventually put you in a better position to sell, whenever that day comes.
One component likely to come up during your annual business valuation process is adjusted EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Adjusted EBITDA can help measure the value of a company and its operating performance. However, there is some subjectivity to adjusted EBITDA, and it requires the input of an experienced advisor to be accurate.
In this article, you’ll learn everything you need to know about adjusted EBITDA, including common EBITDA adjustments and how to calculate them. You’ll also find out what adjusted EBITDA can tell you about your business and how you can best use it moving forward.
The Basics of Adjusted EBITDA
As mentioned, EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization.” It’s a figure used heavily in the merger and acquisition (M&A) process for businesses in the lower middle market (companies with revenues between $5 million and $25 million).
Here’s a breakdown of EBITDA components:
- Earnings: You may also see this referred to as Net Income. This is the amount of profit remaining after subtracting your expenses, such as costs of goods sold.
- Interest: The cost you pay to borrow money. It is the financing costs associated with business debts.
- Taxes: Your business state and federal income taxes.
- Depreciation: This is a non-cash expense used to calculate the cost of a tangible asset over its useful life.
- Amortization: This is similar to depreciation, except it refers to loans or intangible assets like intellectual property and Goodwill.
It’s important to note that EBITDA is a “non-GAAP” financial measure. GAAP stands for “Generally Accepted Accounting Principles.” To be GAAP-compliant, a financial metric must meet four standards:
- Objectivity
- Materiality
- Consistency
- Prudence
Adjusted EBITDA doesn’t make it past the first metric, since it is a subjective measure. Rather, it’s a tool used to better understand a company’s profitability and financial performance, primarily because there’s room to adjust for one-time expenses and other extraordinary line items. This is where the “adjusted” portion of adjusted EBITDA comes in.
Common EBITDA Adjustments
Advisors can adjust EBITDA to account for things such as non-recurring items and other inconsistencies. Doing so can provide a more accurate measure of a company‘s operating income. Common EBITDA adjustments include:
- One-time professional fees
- Non-standard repairs and maintenance
- Excess inventories caused by supply chain issues
- Startup costs
- Owner salaries and discretionary expenses
- Arbitrations or one-time disputes
- Restructuring costs
- Redundant assets, such as those not used to run the business
By removing these non-operating expenses, along with interest expenses, tax expenses, and amortization expenses, a clearer picture of a company’s operational value emerges.
How to Calculate Adjusted EBITDA
The adjustments that your advisor makes to your EBITDA are also referred to as add-backs. Your advisor will analyze your operational expenses to determine what add-backs should be removed. This process is known as:
- Normalizing EBITDA
- Normalizing the Profit and Loss Statement
- Normalizing cash flow
Your advisor will then likely run calculations on the EBITDA margin. The EBITDA margin expresses EBIT as a percentage of total revenue. Essentially, it demonstrates how much cash your business generates from each dollar of revenue that you earn. The higher your EBITDA margin, the more desirable your company is to buyers.
What the Value of Adjusted EBITDA Tells You About Your Business
Adjustments allow you to account for discretionary spending decisions made by the current owner. It also allows you to account for any other abnormalities and liabilities that could be impacting your company’s cash flow. Adjusted EBITDA provides a better representation of cash flow from operations.
As a seller, Adjusted EBITDA can be an incredibly useful tool. For instance, let’s say that you recently bought out one of your partners. There are legal fees associated with doing so.
These fees would show up on your financial statements as legal expenses. They would impact your free cash flow, which is a measure of how much cash you generate annually that is free of any obligations, whether they be internal or external.
If you were looking to sell, your business would not seem as profitable because these expenses reduce your bottom line for that year. However, this does not accurately represent your true cash flow from operations. The legal fees are not something that occurs every year. In fact, they may not occur ever again.
Your advisor has the ability to remove these expenses and adjust your EBIT to reflect these as one-time expenses. Your Adjusted EBITDA serves to show your true operational efficiency.
How to Use Adjusted EBITDA
Adjusted EBITDA is not the only thing used when calculating the value of a business. But it can be a useful tool to more accurately determine the fair market value of a business. During the M&A process, adjusted EBITDA will be used alongside other financial metrics found on the income statements and balance sheets.
Your advisor will use adjusted EBITA as a measuring stick to see how your business compares to others in your industry. Comparing your EBITDA margin to that of your competition allows you to determine whether you are as efficient with cash as they are.
Additionally, your advisor will likely apply an EBITDA multiple to put an actual value on your business. To do so, your advisor will research closed transactions and then rely on their expertise to make their own judgment about what end of the “EBITDA multiple” range your company lands on.
If this figure is high, it could potentially mean that your company is less risky. If it’s low, your company may be riskier. However, this is not always the case. Your advisor will have a better understanding of how to apply the multiple and what it means to your business, especially as it relates to the industry you’re in.
Adjusted EBITDA Should Be Part of Your Annual Valuation
It’s wise to have annual business valuations as part of managing your business operations. These valuations provide a more accurate representation of where your business stands, protecting against the valuation gap that appears all too often during the formal M&A process. If your company is undervalued, a valuation allows you to identify pain points so that you can improve your operations.
One key component of the valuation process is adjusted EBITDA, which serves as a proxy for operational cash flow. By removing things like tax expenses and one-time abnormalities, you gain a better understanding of how efficient you are with the cash your business earns from operations. Although it’s a subjective figure, it still allows you to compare your company to others in your industry.
Because adjusted EBITDA is subjective, it’s best to trust the process to experienced advisors, such as those at Allan Taylor & Company. No matter where you are in the M&A process, our team can help you reach your goals. Contact us today to learn more.
