In evaluating a company’s performance, EBITDA is capital neutral. It is not affected by decisions related to how a company finances its balance sheet (i.e., debt, equity, or a mix of both) and it excludes certain non-cash expenses like depreciation and amortization. 

While some view EBITDA as a proxy for operating cash flow, earnings and cash flow are calculated using two completely different accounting methods—i.e., the accrual vs. cash basis of accounting. Since EBITDA is based on accrual figures, it does not accurately represent the cash the company has collected. So, to value a business, acquirers and lenders should consider looking beyond EBITDA, and analyze free cash flow.  

Adjusted EBITDA or quality of earnings

Adjustments to EBITDA are made to “strip out” non-recurring and/or non-operating transactions to reflect the annual “run-rate” or normalized earnings of the company. These adjustments fall into two broad categories: (i) fact-based adjustments and (ii) pro forma adjustments.

Fact-based adjustments relate to items that are non-recurring and unusual in nature and typically include:

GAAP adjustments: Adjustments to reflect the company’s records consistent with Generally Accepted Accounting Principles. Examples include cash to accrual, interim period vs. year end, and capitalization vs. expensing of cost. Cash to accrual adjustments include recording pre-paid expenses, deposits, payroll accruals, etc.

• Interim period vs. year-end adjustments include: 
  • (i) inventory true-up for physical count and obsolescence; (ii) bonus accruals; (iii) analysis of sales returns, warranty and self-insured liabilities; and
  • (iv) allowance for doubtful accounts.
• Typical examples relating to the capitalization vs. expensing of costs include: (i) expensing direct labor and overhead costs to operations rather than capitalizing them as part of inventory; and (ii) expensing repairs and maintenance that meet the criteria for capitalization. 

Owner’s compensation and benefits, including discretionary expenses: Owner salaries are often not market relative to a salary that would be paid to a third-party manager. Extraordinary owner salaries need to be added back to calculate normalized EBITDA. Further, it is not uncommon wherein the company compensates family members who do not play a role in the business, expensive family vacations, and other discretionary purchases.

Rent of facilities: Most companies do not own the facilities they occupy, and may rent them from a holding company owned by a shareholder. The rent is often arbitrarily set. EBITDA would be adjusted to ensure market-related rent.

Management fee: Portfolio companies are usually charged a management fee by private equity owners. This is typically added back to EBITDA assuming the private equity owner does not perform functions that are necessary to operate the day-to-day business.

Unrealized gains or losses: This represents gains or losses that do not have actual cash flow impact and have been recognized in the P&L through journal entries. Examples include unrealized foreign exchange gains or losses from the translation of foreign currency-denominated assets and liabilities and unrealized gain or losses from investments.

One-time expenses, such as settlements and claim recoveries, transaction fees, and severance, including: 

• Lawsuits, arbitrations, insurance claims, and one-time disputes are considered extraordinary items; hence,  an EBITDA addback.
• Legal fees associated with the transaction and legal disputes.
• Restructuring charges, including severance, are considered non-recurring items. 

Pro forma adjustments

Pro forma adjustments relate to events that are normalized to reflect the annual “run-rate” EBITDA impact. Typical adjustments include:

Start-up costs: If a new business line has been launched during the period being analyzed, the associated start-up costs should be added back to EBITDA. This is because the costs are non-recurring, and will not continue going forward. However, if the company is in the growth stage and expects to open new stores or locations year-on-year, the opening costs can be considered as recurring expenses.

Lost customers or new customers: Significant lost customers or new customers can be presented as pro forma adjustments as if such loss or gain took place at the beginning of the period being analyzed. However, if the company operates in an industry where its customer base is highly volatile, and gaining or losing customers are recurring events, these can be considered as ordinary course.

Discontinued products and discontinued operations: EBITDA attributed to the discontinued product, discontinued operations, and store closures can be removed from EBITDA to reflect the normalized earnings going forward.

Run-rate adjustments for acquisitions or divestitures of businesses.

Run-rate adjustments for natural disaster, for example, recently hurricanes have impacted operations across the country. 

Run rate adjustments for employee turnover, such as a gap between someone leaving and a replacement hire. 

Stand-alone costs: In a “carve-out” transaction where the company is a division of a larger entity, post transaction, 
the business will require an accounting department and other back-office functions.

Synergies: As a product of a merger or combination of two entities, synergies may result due to increased purchasing power, cross-selling, payroll cost savings, etc.

Insight

EBITDA adjustments, depending on the specific situation, will be assessed in the contest of the business. There are no hard and steadfast rules. Interpreting the impact is an art that comes with experience and exposure to different industries and circumstances.