EBITDA Normalizations: The Do’s and Don’ts for Accurate Assessment

Importance of Getting the Normalizations Right

The EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) holds a significant position as a key performance parameter. It serves as a metric to evaluate a company’s operational efficiency and profitability. However, there is probably only a few companies out there, where the reported accounting EBITDA shows the full picture of businesses operating result. In order to arrive at a meaningful EBITDA number (adjusted EBITDA), EBITDA is normalized for any aperiodic, non-recurring items. If normalized correctly, analysts can eliminate distortions caused by non-recurring or non-operational items, providing a clear picture of a company’s sustainable performance. However, if done incorrectly, the adjusted EBITDA can even disrupt the picture even further and lead to misleading conclusions about the performance of a company.

Common Acceptable Normalizations

When it comes to EBITDA normalisations, the focus is on identifying and adjusting for items that are non-recurring, non-operational, or non-market standard. These normalizations aim to present a more accurate representation of the company’s core business operations. Let’s delve into some common acceptable normalizations:

Non-market standard owner’s compensation: especially in the smaller cap segment, where ownership and management is not separated, owners tend to compensate themselves either strongly above market-related rate, or below. In order to account for this item accurately, total owner’s compensation should be added back to the EBITDA and average market-rates should be deducted.

Personal & non-market costs: it is common practice, especially in smaller cap high margin businesses to account in the P&L for personal costs of senior management and owners via company accounts. The idea behind this logic, is to minimize the tax exposure by reducing taxable income on the P&L.

The correct way to account for this is to fundamentally understand:

• if such costs are market-standard
• if such costs would continue to exist in case of a takeover / merger.

If both of the cases are not true, one should specifically adjust for such items. In the contrary case not.

“This, together with non-market owner compensation is by far the most common adjustment to EBITDA we see. It is crucial to use common business sense to understand, if such costs are indeed non-market standard and if the new buyer will have to carry them to the same degree. Otherwise it can get pretty creative”, says Fabian Kröher, Executive Director at Winterberg Group.

Non-Operating Income and Expenses: EBITDA focuses on operational performance, so non-operating items, not relating to the business activity of the company, including any foreign exchange impact, dividend income from investment activities, income/losses from any activities, which are not going to be part of the business in case of a potential merger/takeover should be adjusted.

Non-arms-Length Revenues and Expenses: when evaluating the core value of the business, it is important to evaluate, which part of revenues and EBITDA are related with associated entities. In certain cases, the company may book non-market-related services and revenues, which may have an impact on the EBITDA. Such items, should be adjusted accordingly, if all contracts would have not been there, in case of a different ownership/management.

Real estate item: in case where the entity is the owner of real estate facilities, the target company may not display any rent expenses in the P&L, or display non-market related costs. Real estate and companies however are valued at different quasi multiples. Therefore, in order to accurately account for the real-estate, for the Company: one should add back, if any, existing rent payments in favor of the company and deduct a market-standard rent, which would have been paid, in case of a different ownership. For the real estate: one needs to divide the resulting market-standard net operating income (NOI) by a market-standard capitalization rate.

Restructuring Costs: Expenses incurred during major restructuring efforts, such as severance payments, facility closures, or reorganization charges, are typically considered non-recurring. These costs should be normalized to provide a clear picture of ongoing operations.

Mergers and Acquisitions: Transaction-related costs, including legal fees, due diligence expenses, and integration costs, are often excluded from EBITDA. Such expenses are specific to the merger or acquisition and are not reflective of the company’s day-to-day operations.

Other One-Time Events: Certain extraordinary events, such as natural disasters, litigation settlements, or regulatory fines, have a significant impact on a company’s financials but are not indicative of its ongoing operations. Normalizing for these events helps present a more accurate financial picture.

It’s important to note that these normalizations should be verifiable. They must be supported by appropriate documentation, such as financial statements, disclosures, or management explanations, to ensure transparency and credibility.

Non-Common Normalizations

While some normalizations are widely accepted, caution must be exercised when dealing with non-common normalizations. These are items that may be used to manipulate EBITDA artificially or obscure the true financial health of a company.

Let’s explore a few examples:

Operating Lease Adjustments: Some companies try to book operating leases below the EBITDA line to artificially boost their EBITDA. By doing so, they understate their lease expenses, resulting in an inflated EBITDA figure. Proper normalization requires adjusting these lease expenses to reflect their true impact on the business.

Release of Reserves: Companies occasionally release reserves, which are funds set aside to cover future contingencies, to artificially increase EBITDA. These reserves are meant to address potential losses or expenses and do not represent real value created by the company. Adjusting for such releases is crucial to obtain an accurate EBITDA figure.

Questionable Revenue Recognition: Some entities may engage in aggressive revenue recognition practices, recognizing revenue prematurely or inflating sales figures to enhance EBITDA. Identifying and normalizing these practices ensures a more reliable assessment of a company’s performance.

Bad Business Performance: although claimed to be a one-off, the company may face difficulties with the overall industry trend, internal personnel problems etc. Such items indeed should not be normalized for, as the potential new owner may indeed face similar risks after a takeover.

Non-Standard Accounting Practices: Companies may employ accounting tricks, such as capitalizing expenses that should be treated as operational costs, to manipulate EBITDA. Normalizing for such practices involves adjusting the financials to align with industry standards and common business sense.

Conclusion

“EBITDA is a valuable metric for assessing a company’s operational performance. However, to make informed decisions, it is crucial to normalize EBITDA by eliminating distortions caused by non-recurring, non-operational, or non-market standard items”, says Fabian Kroeher, Executive Director at Winterberg Group.

By following the do’s and don’ts of EBITDA normalizations, analysts can ensure a more accurate representation of a company’s sustainable performance. Transparency, verifiability, and adherence to accounting standards play vital roles in achieving reliable EBITDA figures, empowering investors and stakeholders with the insights needed for informed decision-making.