Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
- Understanding the Accredited Investor Rule 501 of Regulation D - February 27, 2024
- Which is Best – Business Broker, M&A Advisor, or an Investment Banker? - October 2, 2023
- How To Find A Business On Sale - August 16, 2023
EBITDA Margin and Adjusted EBITDA Margin are similar measurements used by business owners and others who value businesses for sale. Let’s break down the two terms to help your understand which measurement of profit and cash flow are most relevant for your business.
EBITDA Margin or Earnings Before Interest, Taxes, Depreciation, and Amortization Margin is a measurement of a company’s “top line” operating profitability expressed as a percentage of its total revenue.
EBITDA Margin therefore provides outside investors, business owners, and potential buyers with a clear view of the business’s operating profitability and cash flow, since the valuation excludes interest, taxes, depreciation, and amortization.
Adjusted EBITDA Margin vs. EBITDA Margin
Adjusted EBITDA Margin differs from EBITDA Margin in that adjusted EBITDA Margin normalizes income and expenses, given the fact that not all companies treat income and expenses the same.
Because Adjusted EBITDA Margin standardizes cash flows and removes anomalies, it is a useful tool to compare multiple companies in an “apples-to-apples” fashion.
Adjusted EBITDA Margin is commonly used as a measurement of cash flow for mid-sized businesses because often owners of these businesses commingle personal expenses with business expenses and sometimes over or under compensate those associated with the business.
Adjusted EBITDA Margin Formula
Adjusted EBITDA Margin is calculated as follows:
Net income
Add or Subtract: anomalies such as below or above market rents paid to related parties, below or above market compensation paid to employees, one-time expenses or revenue;
Add: personal expenses deducted by the business paid on behalf of its owners;
Subtract: Interest Expense, Income Taxes, Depreciation, and Amortization.
Divided by Gross Revenue
Benefits of Adjusted EBITDA Margin
Adjusted EBITDA Margin, by definition, allows a direct comparison of multiple companies – regardless of size, location, or industry. It breaks down operating profit as a percentage of revenue, allowing other business owners or investors to understand how much operating cash is generated for each dollar of revenue earned.
Drawbacks of Adjusted EBITDA Margin
Because EBITDA excludes debt, there are some drawbacks to using adjusted EBITDA Margin to measure the performance of a company. Some companies may use EBITDA Margin deceptively to enhance the perception of their financial performance, especially if the company has a large amount of debt.
Additionally, EBITDA Margin is usually higher than profit margin, and companies that have low profitability may use EBITDA Margin as a way to present a deceivingly high level of financial success.
Lastly, EBITDA Margin as an accounting measure is not regulated by GAAP, making it possible for companies to skew numbers in their favor.
In analyzing two companies for the purpose of recasting combined Ebitda for the two companies, Mr. Smith owns company A and Company B operating in the same space ( Helicopter Tours) in 2 different markets.
Company A purchased parts and a new engine for the benefit of Company B.
In recasting Company A numbers, I added back the combined purchase amounts for parts and engine to its earnings to arrive at an adjusted ebitda number. These purchases flow thru Company A P&L for 2017.
Company B had a loss in 2017. The purchases that company A made for its benefit do not show up on company B 2017 P&L.
I interpreted the purchase by Company A for the benefit of company B as a loan, and considered the event a balance sheet event which will eventually impact Company B equity without giving any consideration to company B P&L .
The Buyer called me on this and said, wait a minute, you are overstating the combined ebitda for the companies ( A&B) by the amount of add back you have given Company A, since you have not adjusted down company B ebitda by the same positive adjustment you have given to company A.
While the purchase amounts of parts and engine flow thru company A P&L, the same purchase amounts parts and engine do not flow thru company B P&L.
And since I have not done that, Company B loss is now greater than what it shows as a result of additional expenses ( Purchase of part and engine) that have been documented to its operating expenses.
Kind regards,
P.S: The purchases were made by Year end 2017. And they are to be employed in operations for company B over the next 3 years or so. In essence the Buyer would not have to make these capital purchases ( CAPEX) in 2018, 2019, 2020.
Hi Jacques,
When you have two or more closely-related companies and there is an expense (or income) incorrectly applied, preparing a consolidated Profit and Loss Statement and Balance Sheet addresses the error.
Preparing a consolidated set of financial statements is also necessary when one of the companies pays income to the other(s).
So, your buyer is correct. The EBITDA positive offset you’ve recorded on Company A’s computation should be deducted from Company B’s EBITDA computation to get an accurate Adjusted EBITDA for the collective companies.
That said, Capital Expenditures, such as a helicopter engine and related parts, should not have anything to do with EBITDA other than the depreciation expense. The actual cost of the capital expenditure made for an engine should have been capitalized on the balance sheet and depreciated so the only amount included in the EBITDA computation would be the (D) depreciation of the engine when it is added back.
You may need to amend your 2017 financial statements for the two companies to address the purchase and inter-company loan, then capitalize the engine and related parts, compute depreciation for 2017 on Company B. If you do so, the TOTAL EBITDA for the two companies should be correct and greater than what you’ve computed if you’ve deducted the engine and parts on your 2017 financial statements.
Hope this helps a bit…
Thank you for your input. It makes sense to me the exercise is worth the effort. Thank you again
It’s my pleasure to help you Jacques!
I wish you all the best…
Our company pays me rent for the buildings and I understand it’s above market rate.
Do I want to add back the extra rent paid to me when the buyer is asking for Adjusted EBITDA even if I want them to pay me this extra rent after the sale of the business? I am not selling my property and want to keep it for rental income.
Thanks!
Hi Derick,
If your business is paying you rent which is above market rates, it’s reasonable to believe a third party who buys your business won’t want to pay this above market rate.
And your business is truly producing more cashflow than Adjusted EBITDA would reveal if you do not add the excess rent (over its market rate) back as an adjustment to EBITDA.
So, I recommend adding the excess rent expense to EBITDA.
Most buyers will see through the excess rent you are paying.
Hope this helps you a bit…
When considering EBITDA normalization add backs is a Federal Income Tax credit an add back. It obviously reduces expese and increases earnings, but is a one time event.
Hi Howard,
EBITDA normalization allows you to add back any Federal Income Taxes. To be clear, the addition adjustment is for taxes.
Tax credits are not deductible on a tax return or on a financial statement so they are not added back to get to Adjusted EBITDA.
Hope that clarifies!
When considering EBITDA valuation what debt is subtracted from the EBITDA valuation, and are cash or cash equivalents subtracted from the debt.
Hi Howard,
EBITDA Valuation does not require the user to subtract (or add) company debt, cash or cash equivalents.
Computing EBITDA for a business has nothing to do with amounts on the Balance Sheet such as loans or bank accounts.
The EBITDA Valuation Multiple takes into account debts and liquid assets of a company.