What is Adjusted EBITDA?

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 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. read more and removing anomalies or deviations from a financial metric, say standard EBITDA. This amount has to be separately calculated for valuation and analytical purposes. Public companies are required to report only the figures of standard EBITDA under GAAP rules.

Adjusted EBITDA Formula

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Where EBITDA = Net Income + Interest + Taxes + Depreciation and Amortization

List of Items excluded in Adjusted EBITDA

  • Non-Operating RevenueOne time gain or sale of Property, business, etcRestructuring and ReorganizationReorganizationReorganization refers to the legal process of modifying, merging, or acquiring a company and its assets. Typically undertaken to solve low-profit margins, reasons for revamping vary as per the firm’s needs. For instance, in 2017, Wall Street Journal had announced a major editorial reorganization to help the 128-year-old newspaper adapt to the requirements of digital news reporting.read more chargesUnrealized 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.read moreLegal ExpensesImpairment 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. read moreImpairment of AssetsImpairment Of AssetsImpaired Assets are assets on the balance sheet whose carrying value on the books exceeds the market value (recoverable amount), and the loss is recognized on the company’s income statement. Asset Impairment is commonly found in Balance Sheet items such as goodwill, long-term assets, inventory, and accounts receivable.read moreForex Gains/Losses

How to Calculate Adjusted EBITDA?

Example of Adjusted EBITDA

ABC investments advisory gave 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.read more. Mr. Unreal first calculates EBITDA and then makes necessary adjustments to arrive at the adjusted EBITDA figure. As follows:

  • First, calculate standard EBITDA using the net income from the company’s income statement. Net income includes expenses of interest, taxation and depreciation, and amortization. Add these expenses to the net income figure to get the EBITDA value. 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 unique to the company and usually do not incur by peer companies.

Importance

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.read more to calculate the company’s enterprise value. However, adjustments to EBITDA should not be overlooked as they can significantly impact business valuation. E.g., in 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 Equivalentsread more. An industry multiple of 5-times has been provided.

Enterprise value = EBITDA * Multiple

The enterprise valueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more with a 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 will not incur soon or after the 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 owner’s salary, 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 the enterprise increased by $ 750,000, considering the industry multiple of 5 times. i.e. $ (500,000 – 350,000) * 5Litigation Expenses: Litigation expenses in the form of a lawsuit settlement and legal and consultancy fees are non recurring 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. In contrast, the number of losses on sales of some old machinery can be added to EBITDA as legitimate adjustments.Rent of the facilities: The difference would be negative if the rent charges are above fair market value. Rent profits must be deducted as negative adjustments and vice-versa for the opposite situation.

Advantages and Applications

  • It removes nonrecurring items and anomalies that distort EBITDAIt can be used to evaluate a company’s overall income and determine its annual cash generation.It is 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.read more capacity that an investor would expect.It can be used to make easy and meaningful comparisons across various companies since different companies charge various expenses that are unique or do not incur by companies with similar businesses.Adjusted EBITDA is used to analyze companies to value them for potential acquisitions properly.

Disadvantages

The rules of GAAPRules Of GAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more 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 Salesread more.

Conclusion

Adjusted EBITDA normalizes the EBITDA value that represents the company’s financial health 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 & explanations. We also discussed its advantages and disadvantages. You can learn more about financing from the following articles –

  • Formula of EBITDALTM EBITDAEBITDAR CalculationEBIT vs EBITDA