Owners of closely held businesses use a myriad of metrics to evaluate business performance. Alternatively, when a buyer or third party is looking at a business’s value or performance, they often use the company’s Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) as the key metric to represent the company’s ability to generate cash flow. This is primarily because EBITDA is not impacted by the equity structure of the business, and is a neutral guide as to whether a business is funded with debt or equity.
Since EBITDA is a key factor used in assessing a business’s value and performance, it is a metric that all companies, especially those contemplating a transaction in the next one to three years, should actively track and manage. In tracking, companies need to consider if there are items which currently impact the computation of their EBITDA, but would not exist if the business were owned by a third party. As such, it is often necessary to adjust (or normalize) the computation. The top five adjustments that closely held businesses typically need to consider when determining their normalized EBITDA are as follows.
1. Owner and executive compensation
In a closely held business, owner compensation may be set at a level lower or higher than what the company would need to pay to an unrelated third party executive. It is not unusual for a business to pay the owner what it can afford versus a market rate salary. As a result, the amount paid versus the market rate should be determined annually and accounted for in calculating normalized EBITDA.
2. Renting or leasing versus owning equipment and facilities
Equipment rental or lease agreements may be accounted for as operating leases (i.e., generated rent expense) or capital leases (i.e., generated principal, interest, and depreciation) under rules applied by generally accepted accounting principles (GAAP). Operating leases will reduce both net income and EBITDA, while interest and depreciation associated with capital leases will be added back to net income in arriving at EBITDA. Both of these situations are important to consider if there is a potential sale of the business.
3. Unusual and non-recurring
It is easier to identify unusual and non-recurring items of revenue or expense at the time they occur versus going back, possibly years later, and trying to remember what they were. As such, consideration should be given to any unusual, non-recurring, or non-operating revenues and expenses impacting the computation of normalized EBITDA on an annual basis. Some examples of non-recurring items are; legal fees related to a contract negotiation or defense of a lawsuit, start-up costs and unusual consulting costs.
4. Related party transactions
It is important to consider if there are any transactions with related parties, below or above market rates, for similar goods and services acquired from a third party. This kind of transaction often presents itself when a company rents its building space from a related party. Often, the rent being paid (similar to owner compensation) is based on what the business can afford and not market rates, resulting in a above market rent and lower EBITDA of the business.
5. Other operating expenses
The overall operations of the business should be reviewed to determine if there are expenses a third party would consider unnecessary or excessive. For example, businesses often entertain clients, and the level and cost of that entertainment can vary widely from one business owner to another. These type of discretionary expenses should be reviewed to determine if an adjustment is needed either up or down to arrive at a normalized EBITDA.
While none of these adjustments are overly complex, normalized EBITDA is an important metric that should be assessed annually. Contact Clayton & McKervey to learn more about computing a normalized EBITDA.
