What is adjusted EBITDA (and why it matters)
– EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a profitability proxy that removes financing costs (interest), tax effects, and non-cash accounting charges (depreciation and amortization).
– Adjusted EBITDA begins with EBITDA and then makes additional changes to remove items that are non-recurring, unusual, or specific to a single company so that operating performance is easier to compare across firms or time periods.
Key formulae
– EBITDA = Net income + Interest expense + Income tax expense + Depreciation + Amortization
– Adjusted EBITDA = EBITDA +/− Adjustments
– “Adjustments” are add‑backs or deductions for items the analyst judges as not representative of normal, ongoing operations.
Step‑by‑step: how to calculate adjusted EBITDA
1. Start with net income from the income statement.
2. Add back interest expense (to remove financing structure effects).
3. Add back income tax expense (to remove jurisdictional and tax‑planning effects).
4. Add back depreciation and amortization (non‑cash accounting charges).
– Result at this point = EBITDA.
5. Identify items to normalize. Typical candidates:
– One‑time or unusual expenses (e.g., legal settlements, restructuring costs).
– Owner’s or executive compensation above/below market rates.
– Non‑recurring revenue or gains (e.g., asset sale proceeds).
– Costs related to discontinued operations or redundant assets.
6. Adjust EBITDA by adding back the chosen expenses (or subtracting one‑time income) to produce adjusted EBITDA.
7. Document assumptions and rationale for each add‑back (amount, period, why it’s non‑recurring or not representative).
Checklist: common adjustments to consider
– One‑time legal fees, regulatory costs, or severance payments
– Transaction or deal-related advisory fees
– Losses or gains from asset sales
– Non-cash stock‑based compensation (if being normalized)
– Owner’s personal expenses run through the business
– Rent or lease amounts that deviate significantly from market rates
– Insurance recoveries or large claim proceeds
– Start‑up or pre‑operating costs (if assessing stabilized operations)
Numeric example (worked)
Assumptions for a single year:
– Net income: $600,000
– Interest expense: $40,000
– Income tax expense: $160,000
– Depreciation: $70,000
– Amortization: $30,000
– One‑time legal settlement (expense): $120,000
– Excess owner compensation (amount above market): $80,000
Step calculations:
1. EBITDA = 600,000 + 40,000 + 160,000 + 70,000 + 30,000 = $900,000
2. Adjustments = add back one‑time legal $120,000 + add back excess owner pay $80,000 = $200,000
3. Adjusted EBITDA = 900,000 + 200,000 = $1,100,000
Valuation impact example (illustrative only):
– If an acquirer uses an enterprise value multiple of 6× adjusted EBITDA:
– Value based on EBITDA = 6 × 900,000 = $5,400,000
– Value based on adjusted EBITDA = 6 × 1,100,000 = $6,600,000
– Difference = $1,200,000 — the add‑backs raise implied value by this amount.
What adjusted EBITDA tells you—and its limits
– Usefulness:
– Makes operating cash‑flow proxies more comparable across firms with different capital structures, tax positions, or accounting schedules.
– Common in M&A, lending covenants, and internal performance metrics.
– Limitations:
– Adjusted EBITDA is not a standardized GAAP measure; different analysts may apply different adjustments.
– It can be manipulated if add‑backs are too aggressive (e.g., treating recurring expenses as “one‑time”).
– It excludes capital expenditures and working capital needs, so it is not a substitute for cash‑flow analysis.
– Because it’s non‑GAAP, disclosures and supporting reconciliations matter—ask for backup.
Practical tips for users (quick checklist)
– Always require a reconciliation from net income to adjusted EBITDA.
– Ask for documentation justifying each add‑back (invoices, contracts, or a clear rationale).
– Check historical patterns: are “one‑time” items recurring year after year?
– When comparing companies, align the adjustment methodology across peers.
– Combine adjusted EBITDA with cash‑flow, balance sheet, and capex analysis for valuation or credit decisions.
Regulatory and tax notes
– Adjusted EBITDA is a non‑GAAP measure and not required to appear on GAAP financial statements.
– Owners’ compensation adjustments are often reviewed against tax rules and reasonable‑compensation guidance (see official regulations).
Selected sources for further reading
– Investopedia — “Adjusted EBITDA”
https://www.investopedia.com/terms/a/adjusted-ebitda.asp
– U.S. Securities and Exchange Commission — “Non‑GAAP Financial Measures” guidance
https://www.sec.gov/corpfin/guidance/nongaapinterp.htm
– Electronic Code of Federal Regulations (eCFR) — Title 26 § 1.162‑7 (reasonable compensation)
https://www.ecfr.gov/current/title-26/section-1.162-7
Educational disclaimer
This explanation is for educational and informational purposes only. It is not personalized investment, tax, or legal advice. Consult qualified professionals before making decisions based on adjusted EBITDA or other financial metrics.