What Is Adjusted EBITDA?
Adjusted EBITDA is often used by investors and analysts to measure a company’s profitability – or how much money a business has paying out interest, taxes, and interest on the debt. But it’s also commonly used by companies in other sectors who want to make sure their profitability figures are as clean as possible before going to market.
For example, suppose a construction company wants to build a commercial building and make sure that its profits are accounted for. In that case, it will generally use adjusted EBITDA.
Normalizing EBITDA adjusts for anomalous items to highlight the real running costs or earnings of a business. This standardized metric is used to make more accurate comparisons between businesses and is more relevant than ever before, as businesses rely increasingly on EBITDA figures when making financial decisions.
How to Calculate Adjusted EBITDA?
To calculate Adjusted EBITDA, start by finding “earnings before interest and taxes.” To this number, add back “interest expense,” income taxes,” and adding back “noncash charges.” Non-routine expenses, such as owner’s compensation or subtract any additional expenses present in peer companies but not in the company under analysis.
The formula for calculating adjusted EBITDA is
((Net Income + Interest Expense+ Depreciation and Amortization= EBITDA
EBITDA +/− Adjustments= Adjusted EBITDA.
Adjustments can be Capital Expenditures and Change in Accumulated Depreciation.
What Does Adjusted EBITDA Tell You?
Adjusted EBITDA is a measure of a company’s operating performance that eliminates a firm’s financing and capital structure decisions or other factors outside the company’s control. Companies use adjusted EBITDA to assess and measure their core operating performance and by analysts to compare companies. With adjusted EBITDA, metrics like gross margins and net income no longer reflect hidden expenses.
Adjusted EBITDA allows us to normalize income and expenses since different companies have their unique expense items.
Adjusted Earnings Before Interest, Taxes, and Depreciation (EBITDA) eliminates redundant assets that don’t contribute to the business unit’s earnings. It is a calculation commonly used by investment bankers, making it very attractive when comparing multiple companies in the same industry.
For smaller firms, personal expenses are often included in a business’s earnings and come out in the wash. But as the company grows, it becomes more important to adjust for these costs.
Legal fees, real estate expenses such as maintenance, repairs and insurance claims are non-recurring items. Non-recurring income and expenses that usually reduce EBITDA should also be added back when computing adjusted EBITDA.
Adjusted EBITDA is better understood as a supplement to EBITDA rather than a replacement. Ratios that use adjusted EBITDA are better understood in tandem (and with other ratios) rather than in isolation.
Ratios can help you evaluate companies regardless of size and industry. For example, the enterprise value/adjusted EBITDA ratio compares an enterprise value to adjusted EBITDAs.
Example of How to Use Adjusted EBITDA
The adjusted EBITDA metric is a good indicator of the value of a company for transactions such as mergers, acquisitions, or raising capital. Put simply, adjusted EBITDA helps ensure that you are looking at similarly sized businesses when comparing valuations.
For example, if a company has $100 million in expenses but only makes $90 million in revenue, the company would be classed as having $9 million in assets and $9 million in liabilities, giving it a negative EBITDA multiple of -2x. By contrast, if the same company had $1 billion in revenues but only had $500 million in assets, it would be valued at a multiple of 10x.
Adjusted EBITDA is essentially the net income a company would have if it didn’t deal with “normal” operational costs. It’s used for analysts and investors to determine how a company is doing, independent of how it’s operating. EBITDA adjustments can vary widely from one company to the next.
The biggest adjustments are often different types of expenses, which are added back to EBITDA. Adjusted EBITDA is often higher than your profit because expenses are subtracted.
- Unrealized gains or losses in stocks or cryptocurrencies,
- non-cash expenses like depreciation, and litigation expenses.
- Also, for private firms, the compensation of owners is higher than the market average.
- Any gains/losses caused by exchange rate fluctuations.
- Investment in goodwill,
- share-based compensation.
This number is used to determine a company’s earnings before interest, taxes, depreciation, and amortization. This metric is normally calculated on an annual basis for valuation analysis.
Analysts use a three-year average adjusted EBITDA for the best measure of profitability over time. Once you know the adjusted EBITDA is, you can determine if it’s high or low compared to the industry average: the higher the adjusted EBITDA margin, the better.
EBITDA adjustments are often not made available to the public, and adjusted EBITDA is not a generally accepted accounting principle (GAAP)-standard line items on a company’s income statement.
Reasons for Using Adjusted EBITDA
For many companies, the key metric investors look at is adjusted EBITDA. While everyone doesn’t well understand the term, the number itself can be a good way to measure a business. It is often used when businesses are being valued for mergers and acquisitions or in comparison to the budget/forecast/guidance/expectations.
Good adjustments are non-recurring and don’t reflect future expectations for the business. If you want to see the true profitability, it’s best to remove items like non-recurring items.
Bad adjustments are either attempts to misrepresent a company’s financials or don’t represent the impact.
- Investors and analysts often use adjusted EBITDA to measure a company’s profitability – or how much money a business is making after paying out interest, taxes, and interest on the debt.
- Adjusted EBITDA allows us to normalize income and expenses since different companies have their unique expense items.
- The biggest adjustments are often different types of expenses, which are added back to EBITDA. Resulting adjusted EBITDA often reflects a higher earnings level because of the reduced expenses.
- Good adjustments are non-recurring and don’t reflect future expectations for the business. If you want to see the true profitability, it’s best to remove items like non-recurring items.
- Bad adjustments are either attempts to misrepresent a company’s financials or don’t represent the impact.