Adjusted EBITDA

What is adjusted EBITDA?

Adjusted EBITDA (German: bereinigtes EBITDA, also normalised EBITDA) refers to EBITDA, that is, earnings before interest, taxes, depreciation and amortisation, after correction for special effects. What is stripped out are one-off items, items that economically relate to a different financial year (out-of-period items), non-operating items and transactions that were not concluded on market terms. The metric is meant to show what operating result the company sustainably generates under ordinary conditions. A household that wants to know what it needs to live on per month calculates in a similar way: the one-off repair of the heating is left out, the annual insurance premium is included proportionately.

In the sale of profitable companies, adjusted EBITDA is generally the decisive reference figure: buyers multiply it by a factor (multiple) and thus obtain the company value. It is examined in financial due diligence, the investigation of the financial figures by the buyer or investor. In the company purchase agreement, it is defined for earnings-dependent parts of the purchase price; in loan agreements, it serves as the basis of financial ratios whose compliance the bank monitors (covenants).

From net income to EBITDA

The starting point is the income statement under Section 275 of the German Commercial Code (Handelsgesetzbuch, HGB). Added to net income for the year are taxes on income and earnings and the depreciation of property, plant and equipment and amortisation of intangible assets, including that on an acquired goodwill. The financial result is stripped out.

Formula: EBITDA = net income + income taxes + interest expense minus interest income + depreciation and amortisation

Other taxes such as property tax remain deducted as operating costs under widespread practice. The result is the reported EBITDA before any adjustment.

Differences arise even at this stage that must be taken into account in comparisons. A company can capitalise development costs for internally generated software under Section 248(2) HGB, that is, book them as an asset instead of as current expense. Under the nature of expense method, they then appear as income (other own work capitalised). This increases EBITDA; the expense takes effect only later through amortisation. For companies reporting under IFRS, lease payments since IFRS 16 appear predominantly as depreciation and interest, which increases EBITDA compared with an HGB financial statement. Buyers generally balance out such differences before applying multiples.

Types of adjustments

Adjustments can be divided into two groups. Normalisations free the figures of the past from special effects. Pro forma adjustments, by contrast, anticipate the effect of measures already taken. The first three of the following types are normalisations.

Formula: Adjusted EBITDA = reported EBITDA + one-off, out-of-period and non-operating expenses minus corresponding income ± adjustment to market-standard terms ± pro forma effects

One-off and extraordinary items

Expenses and income that do not recur are adjusted. Examples are the costs of a concluded legal dispute, severance payments in a one-off restructuring, gains from the sale of fixed assets, insurance payouts and the advisory costs of the transaction itself. The yardstick is not the label as one-off but the question whether the item belongs to the ordinary course of business. If supposedly one-off expenses recur every year in a different form, they are part of the running costs.

Out-of-period items

Out-of-period items are expenses and income that economically relate to a different financial year, such as back payments for prior years, income from the release of provisions set too high, or credits from earlier billing. They are allocated to the year to which they belong, so that each year shows the earning power of its own period.

Managing director remuneration and transactions with shareholders

Shareholder-managing directors often draw remuneration that deviates from a market-standard salary. The adjustment is to the amount that a salaried management in the same function would cost. This works in both directions: a salary that is too low reduces adjusted EBITDA, an excessive one increases it. The same applies to rents paid to shareholders, services from related companies at non-market prices and privately motivated expenses. The yardstick is which costs arise after the sale on third-party terms.

Pro forma effects

Pro forma adjustments include changes as if they had been in effect for the whole year: the full-year effect of a price increase during the year, a new major customer, an implemented cost reduction or an acquisition. Buyers generally recognise them only if the measure has been fully implemented and its effect is already visible in the monthly figures.

Quality of earnings in financial due diligence

In financial due diligence, the buyer or investor checks whether the reported result is sustainable and repeatable. This analysis of the quality of earnings starts from the bookkeeping data. The basis is usually the trial balance, that is, the list of all accounts with their balances, and the monthly closings. Each adjustment is checked for supporting documents and justification. Also examined are the recording of revenue in the correct period, dependence on a few customers and the question how much of EBITDA actually becomes operating cash flow.

The result is an adjusted EBITDA from the reviewer's perspective, which often differs from the management's calculation. If the seller itself commissions the analysis, for example as a vendor due diligence, the bidders know this value before their offers. Individual adjustments are then not first negotiated in the exclusivity phase, in which only one bidder is still in discussions.

Significance for purchase price and contract

Because company value is calculated as a multiple of adjusted EBITDA (EBITDA multiple), every adjustment affects the purchase price with the multiple. At a multiple of 8, a recognised adjustment of EUR 100,000 increases the company value by EUR 800,000. The basis is usually the result for the last twelve months (LTM, last twelve months), for fast-growing businesses supplemented by an extrapolation from the most recent months.

In the purchase agreement, the definition gains weight when parts of the purchase price depend on the future result. An earn-out based on adjusted EBITDA requires that accounting principles, permissible adjustments and the treatment of group allocations be fixed conclusively. Group allocations are costs that the buyer charges its new subsidiary for central services such as accounting or IT and that reduce its result.

Limits of the metric

Adjusted EBITDA has the same limits as EBITDA. It is not a cash measure: investments, liquidity tied up in receivables and inventories, interest and taxes are missing. A high adjusted EBITDA can therefore go together with a weak free cash flow, for example if there is ongoing investment in hardware or customers pay late.

There are no binding rules for adjustments. Every item is a proposal of the seller that the buyer can accept or reject. Frequently disputed are expenses for employee participation programmes, start-up costs of new business areas and advisory costs that occur in several years. In loan agreements, banks therefore often cap add-backs in amount, so that financial ratios are not met solely through generous adjustments.

Worked example: calculating adjusted EBITDA

A software company reports EBITDA of EUR 1,800,000 for the last financial year. Management presents the following adjustments:

• Costs of a concluded legal dispute: plus EUR 120,000, interim total EUR 1,920,000
• Advisory costs of the sale preparation: plus EUR 90,000, interim total EUR 2,010,000
• Income from the release of a provision for the previous year: minus EUR 60,000, interim total EUR 1,950,000
• Remuneration of the two founders of EUR 90,000 each instead of a market-standard EUR 150,000 each: minus EUR 120,000, interim total EUR 1,830,000
• Office rent to a shareholder, EUR 40,000 below market level: minus EUR 40,000, normalised EBITDA EUR 1,790,000
• Price increase on 1 October with a full-year effect of EUR 150,000, of which EUR 37,500 already included: plus EUR 112,500, adjusted EBITDA according to management EUR 1,902,500

The financial due diligence recognises the normalisations. It rejects the pro forma effect because data on customers' reaction to the price increase are missing. In addition, it deducts EUR 200,000 of capitalised development costs, because the comparison companies bear this expense in EBITDA. Its value: EUR 1,790,000 minus EUR 200,000 = EUR 1,590,000.

• Company value at a multiple of 8 according to management's calculation: 1,902,500 × 8 = EUR 15,220,000
• Company value after due diligence: 1,590,000 × 8 = EUR 12,720,000
• Difference: EUR 312,500 of EBITDA × 8 = EUR 2,500,000

The entire difference traces back to two items. Whether the price increase holds without customer losses and how the development costs are to be treated decides a purchase price difference of EUR 2.5 million. Both questions can be answered only with data that should be prepared before the process starts.

Distinctions: adjusted EBITDA, EBIT and free cash flow

• EBIT: earnings before interest and taxes, but after depreciation and amortisation. In capital-intensive businesses or with high capitalised development costs, it differs markedly from EBITDA and is therefore considered in addition.
• Free cash flow: the cash surplus after investments and changes in net working capital. It shows how much of adjusted EBITDA becomes available as liquidity.
• Run-rate EBITDA: a result extrapolated to a year from the most recent months. It is a form of pro forma view and is to be used with corresponding caution.

Common mistakes

• Recurring items presented as one-off. Special expense that occurs every year in a different form belongs to the running costs. One implausible item casts doubt on the others as well.
• Only upward adjustments. A list with only profit-increasing items is examined particularly critically. Salaries that are too low or favourable rents should be corrected as well.
• Missing supporting documents. Each adjustment needs a reconciliation to the bookkeeping and evidence. Items without supporting documents are struck out in due diligence.
• Pro forma mixed with normalisation. Anticipated effects should be shown separately so that the buyer can assess them separately.
• Only one year considered. Only a comparison of several years shows whether an item is one-off. A view of three financial years and the last twelve months is common.
• Definition left open in the contract. If parts of the purchase price depend on adjusted EBITDA, every undefined adjustment later leads to disputes over the payout.

Frequently asked questions

What is the difference between EBITDA and adjusted EBITDA?

EBITDA is the unadjusted figure from the annual financial statements; adjusted EBITDA is the same figure without one-off and special effects. Each deviation is disclosed and evidenced individually. In a sale, adjusted EBITDA is usually what counts for the purchase price.

Is adjusted EBITDA a metric defined by law?

No. Neither the HGB nor IFRS prescribes EBITDA, and there are no binding rules for adjustments. What matters is therefore the reconciliation from the annual financial statements and the supporting documents for each individual item.

Who decides which adjustments are recognised?

The negotiation between buyer and seller. The seller presents its list, the buyer reviews it in due diligence, and the result is reflected in the purchase price. Where parts of the purchase price depend on the future result, the agreed list becomes part of the contract.

May the buyer's synergies be included?

Not in the target company's adjusted EBITDA. Cost savings or revenue opportunities that arise only through the combination with the buyer (synergies) belong to the buyer's calculation. Whether the buyer passes on part of them in the price depends on competition in the process.

The Roemer Capital view

In sell-side mandates, we prepare the adjustment list before a prospective buyer receives the first figures. Each item is reconciled to the bookkeeping, evidenced and calculated in both directions, that is, including the corrections that reduce the result. We show pro forma effects separately so that the normalisations are not called into question together with them.

As part of our fractional CFO services, we set up reporting so that one-off effects are flagged already in the monthly closing. If a sale is prepared later, the derivation over several years is available and does not have to be reconstructed retroactively. This does not replace the review by the buyer side's advisers, but it shortens the discussion on individual items.