Since it is the most crucial element that affects the value of the firm, EBITDA adjustment is clearly one of the most significant subject to be careful in M&A transactions. Therefore, this post is to help you in the following matters:

  • What is EBITDA?
  • Reason for calculating adjusted /normalised EBITDA
  • Adjustments to EBITDA
  • Other important notes and Weakness of EBITDA

What is EBITDA

To make the issue more understandable, let me quote a book definition of EBITDA:

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. A measure viewed by investors and bankers as a good indicator of future operating cash flow. Lenders like it because it can help them assess a company’s ability to repay its loans. Shareholders like it because it is a measure of cash earnings before the accountants have added in noncash expenses. (source: business-literacy)

EBITDA is often preferred by the analysts. Depreciation and amortisation are unique expenses that are non-cash and expenses related to assets that have already been purchased. Depreciation is calculated by taking the capital cost of a long-term asset and spreading the cost over its useful life. The aim is to match the cost to the period of benefit. For example, if you buy a machine for £10,000 and plan to use it for five years before disposing of it for nil proceeds, on average the cost each year will be £2,000 (i.e. £10,000 / 5). That is the principle of depreciation. It is an accounting estimate as someone needs to make a judgement on the life of the asset or possible proceeds from disposal. If the same principle is applied to intangible assets (such as patents, licences or brands) it is known as ‘amortisation’. They are subject to judgment or estimates — the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud. The idea of using earnings before depreciation and amortisation is that it eliminates these subjective estimates. (source:

Infograph for EBITDA

What is EBITDA?

Understanding components and drivers of EBITDA (Info-Graph)

Components and drivers of EBITDA

Why adjusted/normalised EBITDA should be calculated?

We adjust EBITDA to reach a value that one-time, irregular and non-recurring items are removed from. In other words, we try to find sustainable EBITDA to dissipate the unceratinty in the future.

Here is a simple list of the major reasons for calculating adjusted/normalised EBITDA:

  • To help the negotiations proceed clear
  • To help writing the financial aspects of the share purchase agreement
  • In order to have an indicator for future cash flows.

Determining the Sustainable EBITDA

Sustainable EBITDA is the amount of EBITDA that is supposed to be generated in the upcoming years, after the distorting items, such as one of transactions, are not taken into account.

We determine such number to be used in the valuation methods and determined EBITDA has a profound effect. Here is one of the most common valuation methods to understand the volume of EBITDA’s effect.

EBITDA Valutaion Method

In addition to sustainable EBITDA, we should determine the “EBITDA multiple” which is the number we multiply the determined EBITDA. This amount is usually determined by precedents and should be agreed upon mutually by the parties of the transaction. (As off the shelve definition, you can think of it as the years that is estimated for the company to generate that amount. However, this is just a way of approach and not the academic definition.)

Formula of EBITDA Valuation Method using EBITDA Multplier

Value of Equity = Value of Operations – Debt

$20M = $30M – $10M

Value of Equity = 6(This is multiple)*EBITDA  – Debt

Value of Equity = Multiple of EBITDA – Debt

Adjustments to EBITDA

Adjustments are generally industry specific and it’s always necessary to keep this in mind. Below, you can find common adjustment types by examples. Also, I tried to order in accordance with their importance but obviously it’s personal.

  1. Non recurring items /one-off
    • Gain/loss on the disposal of fixed assets
    • Cost to sell a business/ entity
    • Revenues with an abnormally high margin
    • Potential cost synergies
  2. Accounting items
    • Provision charge / release in different periods
    • Revenue / cost cut-off issues
    • Operating items recorded below EBITDA
    • Changes in GAAP
    • Audit adjustments impacting EBITDA
  3. Transaction scope items
    • Division not included in the transactions
  4. Pro- forma items
    • Being understaffed in historical periods
    • Acquisition/disposal of an entity/business
    • Costs no longer incurred post-transaction
    • Standalone costs or cost synergies

Weaknesses of EBITDA

Eventhough many advantages, EBITDA also has some weaknesses. EBITDA is a parameter that is created to understand the cash flow of a company but it shouldn’t be used as a substitute for a cash flow. Here are the couple of reasons:

EBITDA obviously overstates cash flow. For example, taxation is a cumpulsory cash expense for a company but unfortunately EBITDA doesn’t take it into acount.

Moreover, EBITDA doesn’t take changes in working capital into account. This attribute may cause trouble in especially fast growing companies. In addition to working capital, capital expenditures, which may cover a big percentage of cash flow in some industries, are not included in EBITDA.

I think adding the depreciation makes sense. Because depreciation is not a cash item, you don’t pay for depreciation expense. However, it’s worth to keep in mind that EBITDA is calculated by adding the value of depreciation.

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