EBITDA is defined as Earnings Before Interest, Taxes, Depreciation, and Amortization. This is a metric that very few smaller businesses track, focusing more on gross profit or net income. However, when it comes to valuing your business and preparing it for sale, it all starts with EBITDA.
So what is EBITDA? It is a business’ operating income and excludes taxes and other non-cash expenses like depreciation. It is meant to be a barometer for cash generated by a business’ operations. Having a clear picture of revenue, operating expenses, and overhead is critical to ensure your business is properly valued. However, the picture is oftentimes not so clear, and adjustments need to be made to EBITDA to get to the true results of operations. This is called adjusted EBITDA.
In the due diligence process, the buyer will utilize a third-party CPA firm to perform a quality of earnings (“QoE”). This analysis looks at the financials and determines what adjustments are required to re-state EBITDA accurately. As a business owner, there are many types of adjustments that you need to understand as you prepare for a sale and a QoE.
Here are a few key EBITDA adjustments to keep in mind for M&A:
GAAP Basis Financials
The universal language of financial reporting is GAAP – Generally Accepted Accounting Principles. These principles guide how public and private companies should record and report their results from operations. It is rare that lower-middle-market businesses keep their books under GAAP accrual-basis accounting. Most companies utilize cash-basis accounting, and this means that adjustments would need to be made to convert the financials to an accrual basis. These adjustments can be significant, especially for service or software companies that have fixed contracts and need to comply with revenue recognition requirements. Other GAAP adjustments would be for facility leases, prepaid expenses, accrued expenses (expenses incurred but not yet paid), bad debt allowance, and inventory.
Owners who are considering a sale should engage a third party CPA firm to perform an audit or review of the financials and have them assist in converting the financials to GAAP. Alternatively, owners can conduct a sellside QoE in order to present adjusted EBITDA, but without having to formally change methods of accounting. Both investments provide a significant return on investment, as your company will often be deemed more valuable when there is less ambiguity in your financial results.
Personal Expenses
Many smaller business owners are very “tax efficient” and may perhaps have personal expenses in the business. Cash sales, vacations, cellphones, vehicles, salaries paid to family members, and other perks would be costs that would not continue with a subsequent buyer. As such, they need to be adjusted out of EBITDA, making the profitability of the business stronger. That said, any such addbacks need to be fully supported with receipts and documentation to be eligible.
One-Time Expenses
Some expenses that are included in EBITDA are not recurring, and they were made one time in response to a specific project, issue, or strategy. These expenses are not on-going and would not be incurred by a subsequent buyer, so they also need to be adjusted out of EBITDA. Things like PPP loan forgiveness, insurance settlements, legal expenses, investments for growth, cost of setting up a new facility, and so on. There are also one-time operational changes that have a financial affect that should also be tracked and adjusted, such as divestiture of a product/service/geography, cancellation of a customer/relationship, price changes from a key vendor, and so on. If any of these expenses are short-term and non-recurring, the financials should be restated accordingly so that the earnings trend is consistent.
Don’t Overlook the Balance Sheet
The focus on EBITDA and profitability sometimes means owners do not focus as much on the balance sheet. This can lead to issues that, in turn, could affect EBITDA when corrected. Some areas to focus on include:
- Bank Account Reconciliation – ensure the cash balances tie to the bank account and there are no aged, outstanding checks
- Accounts Receivable Aging – any receivables that are older than 90 days need to be collected or written off as bad debt
- Accrued Expenses – are there any expenses you’ve incurred but not paid? Things like sales commissions, bonuses, payroll, taxes, etc.
- Inventory – perform a count and ensure the amount on your balance sheet reflects what you have on hand. Any old inventory will be reviewed for obsolescence, so write off anything that you do not believe will be converted to revenue.
Bottom Line | Why Does EBITDA Matter?
EBITDA is the basis for a business valuation. Adjusted EBITDA, however, is the most important number as it more truly reflects the go-forward run rate of earnings from operations. The harder it is for a buyer to understand what your adjusted EBITDA is, the more it can devalue the business overall. As such, it’s important to prepare in advance and ensure your adjusted EBITDA is clear and accurate, as it could result in your receiving millions more for your business.
If you need help determining your own adjusted EBITDA or any other key financial metrics and KPIs related to the value of your business, don’t hesitate to reach out to us today.