EBITDA: What should and should not be included in the calculation.

At Cardinal Capital, we often find ourselves in a position of comparing organizations in Louisiana with similar firms elsewhere in the United States.  The search for apples-to-apples is sometimes a challenge because, as we all know, we’re unique at this end of the Mississippi River and not all business are alike.  I recently wrote about the NPS (Net Promotor Score) as an indicator and ‘normalizer’ of business performance.  Another ‘normalizer’ is EBITDA.  A staple metric for finance and operations folks.

EBITDA is a basic and widely accepted normalizing adjustment for businesses.  It serves as a proxy for cash-flow when deriving business value.  It is a hind-site measure – it tells you what you did historically not what will happen tomorrow - where NPS is a forward-looking indicator.  EBITDA adds expenses from the income statement like interest, corporate income taxes, depreciation and amortization back into net income to determine the firm’s cash flow. An accepted metric or indicator of organizations overall ‘health’.

Normalizing EBITDA before seeking any macro financial transaction can help present the business in a more accurate position. We often find ourselves advising clients to be cautious with the level of “owner’s perks,” and other adjustments, they charge to the business. Below are four categories we run across when advising clients on EBITDA. 

1. Non-Recurring Expenses – These are expenses (or benefits) incurred by a business that wouldn’t normally affect the business’ profitability. Adjustments to this category might include (but aren’t limited to) insurance payouts, moving expenses, and losses from discontinuing operations (like flood losses). However, other typical non-recurring expenses like lawsuits may be questioned by a potential acquirer or lender if the business is in an industry known for frivolous lawsuits. In cases such as these, an acquirer or lender may deem lawsuits a normal, and recurring, business expense that needs to be accounted for in the financial statements and should not be normalized.

2. Personal Expenses – A broad category to say the least. Expenses like travel, meals, entertainment, personal insurance policies, and discretionary bonuses tend to get lumped into this section. Although these expenses can be normalized, that doesn’t mean they should be. We advise the expenses not related to business activities should not be charged to the business.

Here are a few examples:

  • Travel expenses: Recognizing that some may bill travel expenses not associated with the business activities through the business, owners can typically normalize these expenses.
  • Auto expenses: These are typical and acceptable adjustment, since some executives receive compensation or reimbursement for automobiles. The idea here is that an executive shouldn’t drive a car that would make them embarrassed to meet a client.
  • Meals: In most instances, meals should not be eligible. However, exceptions do apply. For example, meal expenses related to selling the business, which are non-recurring in nature and are not related to normal business operations, but are related to the ongoing nature of the business can be included.
  • Entertainment: Entertainment can be vague, which makes it a popular area for owner perks like LSU and Saints tickets. Like other categories, entertainment should be related to business activities, but when exceptions do take place, they can be included.
  • Personal insurance policies, cell phones, and other related perks: These are generally acceptable since they are usually related to the business owner’s involvement in the business.

3. Excess Family Member Salaries – Like personal expenses, some owners provide family members with compensation in excess of what they would pay someone else to do the same job. Considering expenses like these would go away following a sale or refinance – presumably the acquirer would only pay fair market wages.

4. Charitable Contributions – Charitable contributions may be good for your karma and can be normalized in most instances. However, if, for example, a business works with healthcare operations like hospitals, then normalizing charitable contributions to an existing or prospective client’s fishing tournament may be considered a sales and marketing expense.

We hope this quick explanation on EBITDA adjustments provides some clarity on what is (and is not) generally accepted as reasonable expense adjustments. Also keep in mind that from an ethical and transactional point of view, improperly charging expenses to the business may save some money now, but it could cost you more in the long run. We recommend reaching out to Cardinal Capital to address any lingering questions or concerns.

 

Cardinal Capital, LLC, Financial Consultants  No License Required, Baton Rouge, LA