You're already familiar with EBIT and EBITDA.
But what about adjusted EBITDA?
And back up a minute. Why does EBITDA need adjustments in the first place?
That's what we'll delve into in this quick article.
- What is adjusted EBITDA?
- How to calculate adjusted EBITDA
- Adjusted EBITDA vs. net income
- Adjusted EBITDA vs. cash-adjusted EBITDA
- Adjusted EBITDA and EBITDA multiple
What is adjusted EBITDA?
Adjusted EBITDA removes one-time, irregular, and non-recurring items that distort EBITDA.
Quick refresher: EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization.
(And EBIT is EBITDA less depreciation and amortization.)
Since EBITDA measures a company's earnings, it's an overall indicator of that company's profitability. The higher EBITDA, generally, the more profitable a company is.
But one of the downfalls of EBITDA as a comparison metric is that two companies can have the same EBITDA but vary in terms of how leveraged they are.
So adjusted EBITDA—also called normalized EBITDA or standard EBITDA—removes irregular and non-recurring items that might distort a company's EBITDA.
Why use adjusted EBITDA?
Adjusting EBITDA gives a normalized number undistorted by irregular gains, losses, or other items.
In other words: it's a more fair, standard measure of a company's financial performance.
This means it's fair game to use when comparing companies.
Financial analysts, investment bankers, and finance professionals use a company's adjusted EBITDA during valuation.
What are the limitations of adjusted EBITDA?
Adjusted EBITDA, while more reliable and normalized than EBITDA, still has two big caveats.
First, there's no standard or universally agreed-upon list of what can and cannot be included in the adjusted EBITDA calculation. So bad actors can corrupt (or "denormalize") their adjusted EBITDA with some creative accounting.
Adjusted EBITDA's second limitation is that it's not reflective of cash flow, which is an essential overall indicator of a company's financial health.
So you should always consider adjusted EBITDA in the context of at least one other financial metric.
How to calculate adjusted EBITDA
Fortunately, calculating adjusted EBITDA is pretty easy.
It's just EBITDA plus or minus adjustments.
Adjusted EBITDA = EBITDA ± Adjustments
(And if you need a refresher on calculating EBITDA, it's net income + interest + taxes + depreciation + amortization. You can find these on your company's income statement.)
Okay, great. Super easy. But how do you know what those adjustments are?
Common non-recurring expenses and adjustments
Adjustments are one-time expenses (including interest expense) and other nonrecurring expenses.
Here's a non-exhaustive list of common EBITDA adjustments:
- Non-operating income
- Unrealized gains or losses
- Non-cash expenses
- One-time gains or losses
- Stock-based compensation
- Litigation expenses
- Special donations
- Above-market owners’ compensation (private companies)
- Goodwill impairments
- Asset write-downs
- Rentals above or below fair market value
- Foreign exchanges gains or losses
Always keep a list of what you've included in your standard EBITDA calculation: because this is a non-GAAP metric and there's no "standard" way to decide which goes in and what's left out, you might be asked to show your work.
Adjusted EBITDA vs. a company's net income
You're not alone if you're confused about the difference between adjusted EBITDA and a company's net income.
But fortunately, the difference is pretty clear.
And we can derive it from the formula for adjusted EBITDA.
Here's that formula again:
Adjusted EBITDA = EBITDA ± Adjustments.
And breaking out the formula for EBITDA, we get:
Adjusted EBITDA = Net income + Interest + Taxes + Depreciation + Amortization ± Adjustments
So a company's adjusted EBITDA will almost always be much higher than its net income because adjusted EBITDA is net income plus a bunch of other stuff.
Adjusted EBITDA vs. cash-adjusted EBITDA
You might have been asked for your company's cash-adjusted EBITDA.
(This is particularly likely if you're in SaaS.)
Cash-adjusted EBITDA is another variation on the standard EBITDA: it's when you add the year-over-year change in deferred revenue from the balance sheet to EBITDA.
In other words, cash-adjusted EBITDA previews your company's future EBITDA.
Cash-adjusted EBITDA has a lot in common with normalized EBITDA.
It's an EBITDA modification that presents your company in its best light.
And it's also a standard valuation metric.
What is cash-adjusted EBITDA? How do you calculate it?
The formula for cash-adjusted EBITDA is a little more complicated than the formula for adjusted EBITDA, but it's still super simple.
Here it is:
Cash-adjusted EBITDA = 12-month trailing EBITDA + YoY change in deferred revenue
Let's break it down:
12-month trailing EBITDA is the average EBITDA for the previous twelve months.
The YoY change in deferred revenue is the change in deferred revenue from the beginning of that 12-month period to the current month. This is the "cash" that cash-adjusted EBITDA accounts for.
Adjusted EBITDA and EBITDA multiple
EBITDA multiple is a financial ratio that measures how desirable a company is to acquire.
It's also known as the EV:EBITDA ratio, where EV is enterprise value.
Here's how to calculate it:
EBITDA multiple = EV ÷ EBITDA.
The question is: is it better to use EBITDA or adjusted EBITDA in this calculation?
And the answer:
Well, it depends on your goal with your EV:EBITDA ratio.
But because a smaller EV:EBITDA ratio is preferable...
And because you're dividing by EBITDA...
And because adjusted EBITDA tends to be higher...
...many companies will use their adjusted EBITDA to make their EV:EBITDA ratio look better.
And there's a solid argument to be made that it's better this way, too. Since adjusted EBITDA removes the randomness from EBITDA, an EV:EBITDA ratio that uses it is better for investors who want to compare companies.
But if you're trying to sell your company and that valuation uses some multiple of the EV:EBITDA ratio, you want to use the regular EBITDA because it'll yield a higher EV:EBITDA ratio, thereby increasing your company's purchase price.
So it depends on your goals.
Now you know all about adjusted EBITDA.
You know what it is.
How to calculate it.
And how to use it.
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