Adjusted EBITDA is a crucial and widely-utilized financial metric to analyze a company's true operating cash flow.
What is EBITDA?
The abbreviation "EBITDA" means a company's earnings before interest, taxes, depreciation, and amortization. EBITDA is a benchmark you can use in place of revenue, earnings, or net income from the company's income statement to evaluate a company's financial health.
When calculating EBITDA, work out the revenue minus expenses, but ignore interest, taxes, depreciation, and amortization.
What is adjusted EBITDA?
Adjusted EBITDA, sometimes called normalized EBITDA, is a company's standard EBITDA after you calculate the company's earnings before deducting interest, taxes, depreciation, and amortization, then adding or subtracting abnormal variables like interest, taxes, and depreciation.
It's one of the more used financial models, providing a more realistic depiction of a company's operating cash flow.
While the specifics of these EBITDA adjustments will vary widely from firm to firm, they will almost always factor out unusual costs like restructuring costs, share-based pay, and one-time expenses. Because of this, many investors and analysts prefer using adjusted EBITDA to measure a company's profitability in place of other metrics, such as net income.
Some industry insiders refer to it as normalized EBITDA as it provides a normalized number while ignoring deviations and irregularities that may distort EBITDA, such as taxes, depreciation, and interest expense.
EBITDA vs. adjusted EBITDA
The primary distinction between EBITDA and adjusted EBITDA is the exclusion of one-time, non-operating expenses or extraordinary transactions and events. Investment bankers and analysts use data from a company's daily transactions and events to determine a company's actual value, a crucial step in corporate decisions like mergers and acquisitions.
How is adjusted EBITDA calculated?
The first thing you need to do when calculating adjusted EBITDA is track down the data you will need to feed into the adjusted EBITDA formula. If you have the necessary values, you can calculate the standard EBITDA using the formula below:
EBITDA = Net income expenses + interest expenses + Taxes Expenses + Depreciation + Amortization Expenses
Then use the value of standard EBITDA to calculate adjusted EBITDA using the following formula:
Adjusted EBITDA = EBITDA +/- adjustments
What is a good adjusted EBITDA margin?
EBITDA margin represents the ratio of a company's EBITDA to its revenue, with a percentage showing the extent to which operational costs are eating into the company's earnings.
An adjusted EBITDA margin will depend on the industry in which a company operates. Therefore, there is no universal standard for what makes up an excellent adjusted EBITDA margin.
Suppose your company's adjusted EBITDA percentage is high. In that case, it will attract a lot of interest as that suggests you have high revenue with a low cost of operations, and the company can cover its fixed and variable expenses with the money it brings in.
A company's adjusted EBITDA margin should be above the average for its industry. If your adjusted EBITDA margin is lower than average, it could mean cash flow and the company's profitability are below par. Therefore, industry insiders consider an EBITDA margin over 10% good after carrying out the adjusted EBITDA calculation.
What affects adjusted EBITDA?
It's essential to understand common EBITDA adjustments that affect the metric:
Repairs and maintenance
When conducting a review or adjustments, overlook repairs and maintenance. For example, a private business owner will deliberately write off major purchases as maintenance costs to reduce their taxable income.
While this strategy could lower annual payments for taxes, it would ultimately damage the company's value at sale time by lowering historical EBITDA. This means you must thoroughly analyze and re-include any capital expenditures in EBITDA.
It is common for various companies to incur cash and non-cash expenses that ultimately benefit the owner only. For instance, the owner may purchase assets like vehicles, procure life insurance, or go on a family vacation at the company's expense. These costs incurred on behalf of the owner may result in a significant reduction in EBITDA.
It is common practice for businesses to lease rather than buy the space they operate out of. Always make negative adjustments for positive rent income and vice versa.
Litigation costs, such as those incurred in the settlement of a lawsuit or the payment of legal or consulting fees, are non-recurring items you can deduct as adjustments.
It would help if you excluded all earnings and costs associated with discontinued operations from the adjusted EBITDA since the company will no longer generate income from them. A decreased operating income from stopping the production of certain products and services could increase adjusted EBITDA.
This may be necessary because of technological advancements, depreciation, or decreased performance of currently held assets. There is room for either positive or negative adjustments due to the one-time nature of gains and losses from the sale of assets.
What is the purpose of adjusted EBITDA?
The valuation of a company is one of the many aspects of using adjusted EBITDA. It's common practice for financial analysts and others in the finance industry to do valuations before major corporate deals.
For instance, in most cases, amalgamations, mergers, takeovers, and raising capital from private banks, venture capital, and other sources will require the determination of adjusted EBITDA.
Adjusted EBITDA is essential for determining the actual value of a business since it allows for the exclusion of irrelevant factors, such as unusual or fraudulent activities, taxes, depreciation, and interest, that would otherwise skew the valuation in an unfavorable direction.
Another common purpose of adjusted EBITDA is to compare public companies' valuations. Different businesses will have different expenses unique to them that they need to factor in when making adjustments. To account for this, you can use adjusted EBITDA rather than standard EBITDA, which accounts for only a business's primary revenue and expenses.
Contrary to standard EBITDA, adjusted EBITDA aims to standardize income and cash flows while removing anomalies, making comparisons between peer companies in the same industry more straightforward.
You can draw an accurate picture of a company's financial health by calculating adjusted EBITDA, which you can use for planning and forecasting purposes.
Determining the adjusted EBITDA of a company is better for gauging the true financial operating cash flow of a company. You can calculate adjusted EBITDA with several one-time or rare items factored in and eliminating non-recurring items or variables, such as taxes and depreciation.