How Adjusted EBITDA Works

Companies use adjusted EBITDA (EBITDA - earnings before interest, taxes, depreciation, and amortisation) to evaluate and compare similar businesses for valuation analysis and other reasons. They also use it to normalize their profits and expenditures because several companies can have different types of cost items that are special to them. Standardizing EBITDA by eliminating exceptions ensures the resulting modified EBITDA is more reliably and conveniently comparable to the EBITDA of other firms and the EBITDA of a company's industry as a whole. In contrast to non-adjusted EBITDA, adjusted EBITDA attempts to normalise revenue, standardise cash flows, and remove anomalies or oddities.

This makes comparing different business units or businesses in a given sector much simpler. A company often runs small business owners' expenses, adjusting each expense out. Treasury Regulation 1.162-7(b)(3) defines the adjustment for fair reimbursement to owners as "the sum that would normally be compensated for like services by like organisations in like circumstances." You can also include one-time charges such as legal bills, real estate expenses, or insurance claims.

When calculating adjusted EBITDA, you should include the EBITDA, non-recurring income, and certain expenditures, such as one-time startup costs. Adjusted EBITDA should not be used in isolation but rather as part of a broader set of analytical methods for valuing a business or a group of companies. Ratios based on adjusted EBITDA, such as the enterprise value, can be used to compare businesses of various sizes and industries.

Example of Adjusted EBITDA

When calculating the valuation of a business for transactions such as mergers, acquisitions, or capital raising, the adjusted EBITDA measure is beneficial. If a company is valued based on its EBITDA multiple, the value may change significantly after add-backs. Assume we value a company for a sale transaction based on an EBITDA multiple of 6x.

Suppose the corporation has just $1 million in non-recurring or extraordinary costs to add back as EBITDA changes, and the purchase price increases by $6 million ($1 million multiplied by the 6x multiple). As a result, stock analysts and investment bankers scrutinise EBITDA changes closely during these forms of transactions. The changes made to a company's EBITDA can differ significantly from one to the next, but the target remains the same.

Adjusting the EBITDA metric helps to normalise the measure so that it is more standardised, containing the same line-item expenditures as any other comparable business in its sector. The majority of the revisions are usually various categories of costs that are re-added to EBITDA. Because of the lower prices, the adjusted EBITDA also represents a higher level of earnings.

Adjusted EBITDA vs. Net Income

While EBITDA is a measure of a company's capacity to generate consistent profits, net income measures a company's total earnings. Because of this distinction, companies use the net income to estimate the value of their earnings per share rather than their overall earning potential, which is where EBITDA comes in handy.

Net income is a company's profit after deducting operating expenses like depreciation and amortization. EBITDA takes it a step further by removing them totally to provide a clear picture of a company's profitability. Nevertheless, both are good figures to consider when assessing a corporation, as operating income effectively measures the production efficiency of a company's core operations and spending management.