EBITDA (*) is often taken as an approximation of the operating cash flow of a company and is used as a magnitude to value a business by applying a multiple (eg 3 X EBITDA).
Normalizing EBITDA to be a representative indicator of the value of the company makes sense.
An experienced buyer will go beyond EBITDA and focus on free cash flow to value a business (which considers investments in fixed assets and working capital, taxes, etc.), however, the calculation of Cash Flow Free is made from EBITDA, for this reason normalize it to show the best numbers of the company is an important tool for the seller of the business.
1. Income or expenses with related parties.
It refers to companies that carry out transactions with others related to prices lower or higher than those in the market. For example, a company that buys certain products for its operation to another that belongs to the main shareholder of the operator. When the operating company is to be sold EBITDA should be standardized to reflect the market value of those supplies.
2. Income or expenses generated by unnecessary assets.
Unneeded assets are not used in the business operating process. For example, a company whose owner owns an airplane that is occasionally used on trips by company executives. The aircraft is not needed to operate the business and therefore is considered superfluous to the potential buyer. If the expenses associated with the airplane have been paid by the company, those expenses must be deducted to normalize the EBITDA.
3. Salaries and bonuses of shareholders.
Wages of the owner or shareholders are often higher or lower than those paid to an independent manager. In addition, it is common that at the end of the exercise if the owner operates the business, a special bond is declared for the purpose of paying less taxes. These bonds and any extraordinary shareholder salary must be adjusted to calculate the recurring EBITDA, once this adjustment has been made it must be deducted as an expense what would be a market wage of an independent manager.
4. Rental of facilities at prices above or below market value.
Many companies do not own the facilities in which they operate, but pay a rental to a holding company owned by the shareholders of the operator. . This adjustment is similar to that made for related transactions (1). Normally the rent is fixed arbitrarily and above that which would be in the rental market EBITDA should be adjusted by eliminating this expense and adding a market rent expense.
5. Start-up costs.
If a new line of business has been launched during the period in which historical results are analyzed, the associated initial costs must be added back to EBITDA. This is because these costs are irrecoverable and will not be incurred again in the future.
6. Litigation, arbitration, reclamation of claims and disputes.
Any extraordinary income or expense that may have occurred during the review period will not occur again. For this reason, they should be deducted (in the case of an income, eg the recovery of an insurance claim) or aggregated (eg in the case of a demand-side expense) to EBITDA to normalize it.
7. Non-recurring professional fees.
You must identify expenses recorded and related to events that will not occur in the future. For example, legal fees for a specific legal dispute. Not only should the expenses related to the judicial settlement be added to EBITDA, but also related professional fees. The same applies to professional fees of other disciplines and non-recurring nature (special marketing campaigns, special transactions etc.).
8. Repairs and maintenance.
This is usually the category that needs more tuning. Often private business owners record fixed asset investments such as repairs and maintenance to minimize tax payments, although this practice reduces annual tax payments could result in a lower valuation of the company being sold because of an EBITDA History. Therefore, a thorough review is required to add or remove from EBITDA any capital investment recorded as an expense.
If the company for sale provides services using equipment, it usually has spare parts inventories. Often, private business owners will have a generic inventory of parts throughout the year. Like capital purchases, parts purchased during the year will also Recorded as an expense to minimize revenue for tax purposes. If there is more inventory than the generic provision being made, it would be advisable to make a count and value this inventory as close as possible to the time the business is to be sold. Any excess over the provision must be added to EBITDA in order to take into account the actual value of the inventory made.
10. Other Income and Expenses.
Under this category of financial statements there are usually charges that can be added back to EBITDA. Sometimes it is also the “basket” of expenses that can not be recorded in other games. Pay close attention to these accounts and make sure that what is non-recurring is added to EBITDA.
When you are going to sell a business, you often prepare a five-year summary of standardized EBITDA to promote the sale. Nothing prevents you from reviewing the numbers long before you make the sales decision to ensure a good sale. Any multiplier on a higher EBITDA is always better.
(*) Acronym for Earnings Before Interests, Taxes and Amortizations (Earnings Before Interest, Taxes and Amortizations)
This post is based on Erick Hamdan’s “Top 10 ebitda adjustments to make a company for sale” published on June 2, 2014.