Top Five EBITDA Adjustments
Oftentimes, earnings before interest, taxes, depreciation and amortization (EBITDA) are used as a proxy for a firm’s operating cash flow. While EBITDA can be interpreted in different ways, this type of earnings stream can be used to produce a value for a business or business interest by the application of a valuation multiple (i.e., 5 x TTM EBITDA). Business appraisers look beyond EBITDA to value a business. They generally look at free cash flow. Free cash flow begins with EBITDA and proceeds to consider capital expenditures, change in working capital, interest and taxes.
Normalized EBITDA is the adjustment of the historical earnings stream to see what direction the business is headed (meaning, increasing profitability or are they on a decline). The following are the five common EBITDA normalizing adjustments (in no particular order).
- Owner salaries and bonuses are often higher or lower than the norm. Adjustments for reasonable compensation are defined by Treasury Regulation 1.162-7(b)(3) as: “the amount that would ordinarily be paid for like services by like organizations in like circumstances.” Business owners often draw larger-than-usual salaries for tax purposes and sometimes they take smaller salaries to boost reported earnings. To help develop a realistic picture of available earnings, appraisers adjust owner’s compensation to remove “owner bias”, which better reflects the true financial performance in the hands of a hypothetical prospective buyer inherent in the definition of fair market value.
- Rent paid to a related entity that owns the business is often greater than the going market rent. In the case of above market rents, EBITDA is increased when adjusting rent to market rates. Below market rent would be an adjustment to decrease EBITDA.
- Sales or expenses that are not at an arm’s-length transaction. Examples might be, if we have related entities selling to each other at marked-up rates and/or cross use of employees.
- Non-recurring income and expenses are items that usually increase EBITDA. Examples might be one time start-up costs, legal and/or professional fees to organize or defend the business in litigation.
- Repairs and maintenance is probably one of the most overlooked expense item on the income statement. Often, owners may aggressively expense capital assets which should be capitalized and depreciated over time on the balance sheet.
How can American Business Appraisers help?
Business valuations require a significant amount of careful consideration and judgment. Our experienced staff recognizes and quantifies a business’ normalized adjustments. Call us to discuss any specific valuation needs. Every individual situation is different and not everyone requires our certified appraisal services and sometimes just talking with one of our appraisers is all that may be necessary. With our initial consultation, there is no cost or obligation to you. We promise you two things; first, to invest a reasonable amount of time to gain an understanding of your specific requirements, and second, our communication will be kept confidential. We invite you to visit our website at www.abavalue.com to see for yourself the services we offer, along with our qualifications.