Adjusted or normalized EBITDA is one of the components in determining a company’s valuation, as well as 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 compliance calculations of the business. Arriving at this calculated number is more of an art than a science and involves giving a seller credit for any non-recurring, personal, and extraordinary expenses run through the income statement that are not related to the future ongoing operations of a company. It is also important to adjust EBITDA for other expenses the business either desperately needs or has not been capturing properly.
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, costs related to discontinued operations, severance or termination expenses, recruiting fees, or consulting fees, to name a few. Expenses that repeat on a consistent basis are not considered non-recurring, for example, consistent use of consultants or cost related to R&D or business realignment/restructuring. Also, employee compensation, benefits and bonuses are not considered an adjustment. These employment costs are expected by employees, and any changes do nothing more than harm morale, which effects productivity and eventually profitability.
Personal expenses are shareholder specific expenses that are unrelated to the operations of a company 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. These expenses need to be well documented and traceable through the general ledger with enough detail to allow a reasonable person to substantiate the expenses. A rough estimate or an approximation is not good enough and generally not allowable. Other non-allowable personal expenses are meals and entertainment. This is almost impossible to reconcile and usually not a meaningful addback.
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 other act of God related events. Extraordinary expenses do not include inventory write downs or bad debt write offs. These are normal course of business items and should be properly accrued for monthly. Inventory goes stale and becomes obsolete regularly in every business, as well as collectability of account receivables.
Pro forma expenses need to also be reflected in the calculation of Adjusted EBITDA to properly determine a company’s profitability. 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 a market rent. Other necessary expenses that need to be included are accruals for vacation pay, bonuses, audit and tax fees, and salaries for employees who are necessary but have not been hired yet.
As mentioned above, calculating Adjusted EBITDA is more of an art than a science. There are rules and exceptions to every rule. However, all potential add backs must be well defined and traceable to be allowed in the calculation. It also needs to include the proper overhead to continue running the business the same way it did the day prior to closing and into the future.