In the world of small to mid-market mergers and acquisitions, a number that is very important is a company’s adjusted EBITDA. The adjusted EBITDA is meant to find a company’s true normalized earnings by taking away any outside influences or ownership influences on the company’s bottom line. Some companies do not have to make many adjustments in order to find adjusted EBITDA, while some companies may need many adjustments to arrive at adjusted EBITDA.
The EBITDA of a company can be found relatively simply by taking the net income and adding back interest payments, income taxes, depreciation, and amortization. The reason for these being included in the bottom line varies. Interest expense is added back as this is an expense that could be reduced or eliminated depending on how ownership has financed the growth of the company. Income taxes are added back as they are deductible from a company’s tax returns. Depreciation and amortization are both added back as they are both non-cash expenses that a company incurs. A company does not pay any physical cash for its depreciation and amortization expenses, meaning that they do not affect the company’s bottom line. These expenses are all then added back to the company’s net income to compute EBITDA.
Following the calculation of EBITDA, further adjustments are made to the number to try and get to the normalized earnings of a company in a given year. There are a few categories that these adjustments can fall into, the first is an owner’s compensation adjustment, the second are expenses that are not going to continue following a transaction, and thirdly, one-time income or expenses that are an anomaly and not typical in a fiscal year. A key feature that must be true of every adjustment is that it must be able to be sourced back to the income statement. Balance sheet transactions are not eligible to be added back and included in adjusted EBITDA.
Owner’s compensation is an adjustment that is fairly common across industries and can either be positive or negative and varies based on every scenario. In the first case, sometimes an owner is making much over the normal salary for an owner in their role and is expecting to exit the business after a transaction. In this case, the excess salary paid to this owner compared to a fair market rate will be added back to EBITDA. The opposite is true if the owner is making less than a fair market rate, then any amount that the market rate exceeds the owner’s true compensation will be negatively added back. Distributions, however, do not count towards a potential adjustment since they do not have an impact on the income statement. This gives a clearer picture of what the business would be earning if the owner were paid at a market rate.
The second typical category is expenses that are not expected to continue after a transaction. These expenses can take many forms and some companies have many more of these add backs than others. These expenses could include golf or vehicle expenses that are personal to ownership that will not continue once the owner is no longer with the company. This helps to show the number of expenses that were going towards generating revenue for the company and excluding the expenses that were personal in nature to the owner that will not continue into the future.
The final category of adjustment that exists is a one-time expense or income that was some sort of anomaly. Typical examples of this would be abnormally high bad debt or the PPP loan. In the case of bad debt, if a company has a certain level of bad debt that is average for a period of time with an outlier due to a customer not paying its debt, it would usually be reasonable to add that back since it was a one-time expense that is not normal for the company. On the other hand, there can also be a negative adjustment for income such as a PPP Loan or a gain on the sale of an asset, these are not typical income for a company and should in this case, be negatively adjusted for.
In the end, the point of all these adjustments is to see what the normalized earnings for a company over the past few years has been, taking out any anomalies and influence of current ownership, so a buyer can see what the normalized earnings of the business have been.
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