Business Buyers Will Always Check For This… It Could Be Costly
Blog Series 4 of 6
Author: Mark Mroczkowski
Adjusted or normalized Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) is one of the components determining a company’s valuation and establishing debt financing and its various loan covenants. Once Adjusted EBITDA is established through a quality of earnings analysis; it becomes the baseline for future performance measurement, incentives, and business compliance calculations. Arriving at this calculated number is more of an art than a science and involves increasing EBITDA for any non-recurring, personal, and extraordinary expenses run through the income statement that is not related to the future ongoing operations of a company. It is also important to adjust EBITDA downwards for other business expense increases needed or those expenses not previously captured correctly.
Non-recurring expenses are one-time, non-repeatable expenses incurred by a company that a potential buyer would likely not incur in the future. These expenses could include start-up costs for new product lines, facility relocation expenses, expenses related to discontinued operations, severance or termination expenses, recruiting, legal or consulting fees. Employee compensation, benefits, and bonuses are not considered an adjustment.
Personal expenses are shareholder-specific expenses unrelated to a company’s operations and expensed through the income statement. These expenses could include cars, computers, travel, hobbies (e.g., country club dues or airplane costs), healthcare for non-employee family members, or other similar expenses. Such expenses must be well documented in enough detail to allow a reasonable person to substantiate the expenses.
Extraordinary expenses are one-time expenses or losses that arise from significant events that were not driven by the ordinary course of business. Examples include lawsuits, settlements cost, losses related to a customer bankruptcy, product recalls, warranty-related expenses, or natural disasters. Extraordinary expenses do not include ordinary business expenses such as inventory write-downs or bad debt write-offs.
Pro forma expenses also need to be reflected in adjusted EBITDA calculation to determine its profitability correctly. Owners’ compensation or rent expense to a related party needs to be adjusted to properly reflect the fair market value of a person’s wages or market rent. Other necessary expenses that need to be included are accruals for vacation pay, bonuses, audit and tax fees, and salaries for essential employees required to be hired.
Calculating adjusted EBITDA to arrive at a business valuation is more of an art than a science. All potential add-backs must be well defined and substantiated to be considered in the calculation. Adjusted EBITDA must include all direct and indirect costs necessary to continue running the business after it is acquired.
EBITDA is Not Cash Flow
The business world often refers to earnings before interest, taxes, depreciation, and amortization, more commonly known as “EBITDA.” Public companies, private companies, business owners, investment bankers, lenders, valuation firms, and the mainstream business media constantly reference EBITDA and use it as a business term to negotiate value, define agreements, and reference cash flow. However, EBITDA is not cash flow and may or may not approximate cash flow. EBITDA is not a measurement recognized under Generally Accepted Accounting Principles (GAAP). The term EBITDA was created in the 1970s to demonstrate the cable television industry’s cash flow generation potential and was also used by leveraged buyout firms. Over time, this non-GAAP metric has taken center stage and is widely used to demonstrate a company’s financial health. Unfortunately, this metric ignores certain cash expenditures that must be paid, such as capital expenditures, debt service, taxes, and changing working capital requirements. These cash outlays must be understood and adequately reflected in any cash flow analysis and company valuation.
Buyers care that a business under their ownership can: (i) reinvest in and expand its capital assets (capital expenditures), (ii) service its debt, (iii) give raises and bonuses to its employees, and (iv) deliver equity returns to its shareholders.