EBITDA Adjustment.
EBITDA is a
proxy for operating cash flow. While EBITDA can be interpreted in different
ways, it is often used to value companies.Therefore, because EBITDA can drive
the valuation of a company, normalizing it to present the best financial
representation just makes sense. A smart buyer will look beyond EBITDA and
focus on free cash flow to value a
business (which would consider capital expenditures, interest, taxes, etc).
However, the
calculation usually starts with EBITDA and proceeds from there, so knowing how
to normalize EBITDA and present as high a number as possible is a very valuable
skill for company owners to have.
CONSIDERABLE EBITDA ADJUSTMENTS.
Here are some
of the best normalizing adjustments that is important to do in these
calculations before you put your business up for sale. At the very least, it
should save you money when you hire an investment banker to market your
company.
1. Non-Arms-Length
Revenue or Expenses
This refers
to a company that enters into transactions with related parties at a price that
is lower or higher than market rates. An example would be if your operating
company buys supplies from another company owned by a major shareholder at
prices higher than market value. When your operating company goes up for sale,
you would normalize EBITDA to reflect the fair market value of these supplies.
2. Revenue
or Expenses Generated by Unessential Assets
Redundant or
Unessential assets are not used to run
the business. Imagine that your business owns any recreation park that is
occasionally used for company functions or as an incentive for good performance
among your employees. The recreation park isn't really needed to run the
business - it would be unessential to a buyer. Therefore, if the expenses
related to this recreational park have
been paid for by the company, these expenses would be added back to normalize
EBITDA.
3. Owner
Salaries and Bonuses
Owner salaries are often higher or lower than the regular salary that would be paid to a third-party manager. Also, when owners manage the business, a bonus may be declared at the end of the year to reduce income taxes. This bonus and any extraordinary owner salaries need to be added back to calculate recurring EBITDA. An estimate of the third-party manager compensation would be deducted. The typical result, particularly if large year-end owner bonuses have been paid, is an increase in EBITDA.
4. Rent
of Facilities at Prices Above or Below Fair Market Value
Many
companies do not own the facilities they occupy, but instead rent them from a
holding company owned by a shareholder. This is similar to related party
transactions that need to be adjusted, but I single it out as a separate point how
frequently it occurs. The rent is often arbitrarily set above the going market
rent. EBITDA would be adjusted upwards by adding back the arbitrary,
non-arms-length rent and subtracting the true market rent.
5. Start-Up
Costs
If a new
business line has been launched during the period when the historical results
are being analyzed, the associated start-up costs should be added back to
EBITDA. This is because the costs are sunk and will not be incurred going.
6. Lawsuits,
Arbitrations, Insurance Claim Recoveries and One-Time Disputes
Any
extraordinary income or expenses that may have been settled during the review
period would not recur. Therefore, they would be deducted (in the case of
income such as an insurance claim recovery) or added back (in the case of an
expense such as a lawsuit settlement).
7. One
Time Professional Fees
Look out for
expenses incurred that relate to matters that do not recur in the future. An
example is legal fees a business may incur in settling a legal dispute. Not
only would you add the settlement expense back to EBITDA, but you would also
add back the related legal expenses. The same applies for accounting fees on
special transactions or marketing costs if you did a one-time marketing
campaign.
8. Repairs
and Maintenance
One of the
most overlooked categories to review is repairs and maintenance. Often, private
business owners will aggressively categorize capital expenses as repairs in
order to minimize taxes. While this practice may reduce annual taxes, it will
hurt the valuation when the business is sold by reducing historical EBITDA.
Therefore, an adequate review to separate and add any of these capital items
back to EBITDA is a must.
9. Inventories
If your
company provides services using equipment, there is usually parts inventory on
hand. Often, private business owners will carry a general allowance of parts
inventory throughout the year (say $25,000 for a small warehouse). Like capital
purchases, parts acquired during the year are also expensed to minimize income
for tax purposes. If there is more inventory than the general allowance being
carried, it would be smart to count and value this inventory as close to the
time the business is sold as possible. Any excess over the carried allowance of
$25,000 would be added back to EBITDA in order account for the actual inventory
value carried
10. Other
Income and Expenses
This
financial statement category is usually loaded with items that may be added
back to EBITDA. It is also sometimes the dumping ground for expenses that
cannot be coded elsewhere. Pay careful attention to these accounts, and make anything
that is not recurring gets added back. For example, some companies record
one-time employee bonuses or special donation expenses in this category. These
should definitely be added back to EBITDA.Numbers are not black and white,
especially if you are calculating EBITDA to sell your business. Investment
bankers will prepare a five-year summary of normalized EBITDA to market your
company. There is nothing holding you back from reviewing your own numbers well
before you decide to sell to ensure that you get the best deal when you do.
Ultimately, 5x a higher EBITDA is always better.
Well these
adjustment are vital part of Income Statement, but only for calculation of
EBITDA for valuation purpose we need to adjust these items. Because these
adjustment are something that doesn’t have any connection with the operation of
the business. Hence for valuation of firm or business these adjustments are
recommended to be done.
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