Why Is Adjusted EBITDA So Important in Quality of Earnings?
Author: Elliott Holland
Included in the QoE is the adjusted EBITDA, which helps business buyers understand the value of the business they’re evaluating and can help them negotiate a better price.
Key Takeaways
Quality of Earnings, much like an audit, helps business buyers understand if they’re making a good deal and is a must for due diligence
The adjusted EBITDA represents a company’s earnings with certain adjustments that paint a more accurate picture of the business value
The ROI of getting a QoE with an adjusted EBITDA could be hundreds of thousands of dollars
Conducting due diligence is a critical part of purchasing any business. What does due diligence mean? This process provides detailed assessments of the operations, industry, and finances of the company you’re considering buying. It ensures you’re entering into a great deal and avoiding a nightmare caused by exaggerations or deceptive information from the seller.
The Quality of Earnings (QoE) report provides valuable insights into the financial health of a company, which helps you make better decisions and even negotiate a better deal. Something called an adjusted EBITDA is a key component of the QoE, which considers additional adjustments that ultimately have a huge impact on what you can and should be paying for a business.
This guide will provide a brief overview of the QoE and go in-depth on what adjusted EBITDA is and why it’s important when considering a business deal.
A brief look at the Quality of Earnings report
The QoE is a financial report specific to business buyers. It’s similar to an audit and is a crucial component of due diligence.
The QoE contains important financial information that will help you understand where the company began, where it is now, and where it’s headed.
Evaluating a QoE helps you:
Understand the business’s financial condition.
Make sure you’re going to pay a fair price.
Evaluate revenue sources that are temporary versus permanent.
Verify the information you’ve been given by the current business owners.
Included in the QoE report are the adjusted EBITDA, proof of cash, and profit per product or service. These three elements should create a complete financial picture of a business and its history, profitability, and potential.
What is the adjusted EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Adjusted EBITDA, a key part of the QoE, represents an estimate of the cash flow that business will create for its owner each year. It’s called the “adjusted” EBITDA because the measure gets rid of one-time payments or non-recurring expenses that may impact the accuracy of EBITDA, or it adds back certain line items to the EBITDA.
You can calculate the adjusted EBITDA as follows:
Step 1: Find the EBITDA
Net income + interest and taxes + depreciation and amortization = EBITDA
Step 2: Calculate the adjusted EBITDA
EBITDA +/- adjustments = adjusted EBITDA
Common adjustments that create an adjusted EBITDA include:
An owner’s high salary
Income unrelated to operations
Gains or losses that haven’t been realized
Litigation costs
Depreciation, amortization, and other non-cash expenses
Stock-based compensation
The adjusted EBITDA is often used when raising capital or the business is undergoing a merger or acquisition. The owners may value the company at a multiple of its EBITDA, and that may or may not be an accurate picture once items are added back (add-backs).
Why the adjusted EBITDA is important in a business deal
When you’re buying a business, it’s important to have a full picture of where that company fits in with its competitors and the industry at large.
The adjusted EBITDA provides that perspective with a more accurate picture of the business value. The types of expenses each business deals with vary, so taking away irregular factors from both income and expenses helps to level the playing field. Businesses can be more accurately compared.
Investing in a business means you’re paying a multiple of the business’s cash flow. The QoE and the adjusted EBITDA open up more visibility into that cash flow. Assessing the adjusted EBITDA via a percentage shows you the proof you need to negotiate and maybe even get a lower price that reflects any discrepancies in that percentage.
Say that through the adjusted EBITDA assessment you discover the adjusted earnings are 20% less than initially reported. You could then negotiate a reduction of 20% in the sale price, meaning you’ll save $400,000 in a $2 million deal.
That is an incredible 20X ROI when a QoE investment costs $20,000.
How to analyze the adjusted EBITDA
So, how do you analyze the adjusted EBITDA to make sure you’re going into a great business deal? Let’s walk through the steps you need to take.
First, look at “EBITDA as reported” on the QoE. Then, look at the list of adjustments carefully to make sure they’re items that won’t be moving forward with the business, meaning you will not be paying for them. These are expenses that the business owner ran through the business for their benefit, but you won’t have to.
Then, look at “Total adjustments,” and then the “Final adjusted EBITDA,” which you will be paying a multiple of to buy the business. In this assessment, you want to look at total adjustments as a percentage of the adjusted EBITDA, and you’re likely going to want to look at that in the trailing 12-month period column.
Maybe you’re seeing that the total adjustments as a percentage are pretty large, say 67% of the EBITDA. Look closely at those add-back line items. A large seller’s salary could be a big part of it. When you take that number out, the percentage goes down.
This is an example of how to evaluate each add-back line item. You always need to be sure you’re seeing a reasonable percentage of the adjusted EBITDA. Typically, personal expenses that were run through the business in smaller companies need to be adjusted out, while one-time expenses like maintenance or insurance claims should be added back, as should non-recurring income and expenses that typically lower EBITDA.
With the right due diligence partner, you’ll see all these factors in an easy-to-understand report.
Why work with Guardian Due Diligence?
As a self-funded investor, it’s hard to access the same resources as private equity buyers. But when you work with Guardian Due Diligence, you get a complete due diligence process with our QoE product, which tells you everything you need to know about the deal you’re about to enter into.
We’ve evaluated more than 1,500 deals and have experience with $600 million in transactions. We’re committed to delivering an approach to due diligence that’s completely customer-centric.
Download a sample QoE report today or schedule a call with our team to get started.