EBITDA has a reputation for being a reliable measure of a company’s profitability. After all, it strips away extra elements like financing, tax environments, and accounting rules, which can influence a company’s appearance of financial stability. However, in practice, EBITDA is rarely as tidy as it looks on paper.
When it comes to preparing for deals or transactions, you’ll quickly discover that EBITDA is one of the most commonly manipulated numbers. Sellers make adjustments, also called addbacks, to normalize earnings. This can help smooth over one-time expenses or project an image of profitability. Some are fair, but others stretch credibility.
According to recent deal data, addbacks make up 30% of adjusted EBITDA on a median basis across deals. That means the numbers supporting a company’s valuation might not always represent true, repeatable earnings.
At 5th Line, we believe this makes EBITDA adjustments a must-question area in any transaction. Your team might currently be preparing your own exit or reviewing a potential acquisition. In either case, you’ll need to understand how and why EBITDA has been adjusted—and when to push back.
What EBITDA Is and Why It Matters in Deals
EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
The metric is designed to provide a clearer view of a company’s operational profitability. It does this by removing factors that vary from business to business such as capital structure, tax rates, or accounting methods. This has made it a valuable foundation for assessing and structuring deals:
- Buyers and investors often use EBITDA multiples to value a company (e.g., a business trading at 5x EBITDA)
- Lenders look at EBITDA to assess a company’s ability to service debt
- Management teams rely on EBITDA to benchmark performance against peers and competitors
The appeal of using EBITDA is often that it offers comparability. The catch is that EBITDA means adjusted EBITDA. Let’s explore why those adjustments deserve a closer look.
What Are EBITDA Adjustments?
EBITDA adjustments, or addbacks, are modifications made to company earnings. Adjustments can account for expenses (or sometimes revenues) that sellers argue are not part of the ongoing operations of the business.
In theory, these adjustments serve a practical purpose. They should show how the company might realistically perform under new ownership without the influence of one-off distortions. For example:
- If a company incurred a $200,000 legal fee to settle a dispute that won’t recur, adjusting EBITDA makes sense.
- If the founder has been paid an above-market salary, normalizing that expense helps a buyer see a realistic cost structure.
The intent is fairness and visibility. However, that’s not always the outcome. In practice, some addbacks inflate earnings far beyond what’s actually sustainable.
Common Examples of EBITDA Adjustments
Adjustments can come in different forms and types. Here are some of the most common EBITDA adjustments you’ll encounter:
- Owner salaries or compensation normalization: Replacing above- or below-market compensation with a market-based assumption
- One-time legal or consulting fees: Costs tied to lawsuits, audits, or strategic reviews that won’t repeat
- Non-business travel or entertainment: Personal expenses historically run through the business
- Severance or restructuring costs: One-time layoffs or facility closures
- Pre-opening or expansion costs: Expenses tied to launching a new location or product
- “Personal” expenses: Cell phones, vehicles, or other discretionary items unrelated to core operations
When properly documented, many of these examples of EBITDA adjustments are perfectly reasonable. Problems typically arise when adjustments are applied loosely, repeated year after year, or presented without evidence.
When to Question an EBITDA Adjustment
So how do you separate the valid adjustments from questionable ones? These key questions can help guide your review:
1. Is it truly a one-time event?
- If a company records “one-time” restructuring costs three years in a row, they’re not one-time expenses, and you should determine if they’re part of the operating model.
2. Is it well documented?
- Any addback should come with invoices, contracts, or financial statements that support its legitimacy.
3. Does it improve margins unrealistically?
- Compare adjusted EBITDA margins to industry benchmarks. If the adjustment takes margins from 15% to 40%, some skepticism is warranted.
4. Is it distorting future expectations?
- Buyers should ask: Will these exclusions actually go away after the deal closes? If not, they shouldn’t be removed from earnings.
In your review, the goal is not to eliminate all adjustments. Instead, test them against reality. Adjustments should clarify, not obscure, the company’s earning power.
Why Scrutiny Matters
EBITDA adjustments might look small on their own. But added up, they can swing valuations dramatically. Consider:
- A company with $5M in EBITDA trading at 6x is worth $30M.
- If adjustments inflate EBITDA by 20%, that same company suddenly looks like it’s worth $36M.
The $6M gap based on the two EBITDA values represents real money in a deal. For buyers, it can make up the difference between a fair valuation and overpaying. On the seller side, it can drive a smooth exit or lead to credibility concerns that drag out diligence timelines.
Final Thoughts
Even for companies with detailed reporting, there’s no single set of financials that can perfectly capture normalized earnings. However, due to their significant impact, it’s important to remember that EBITDA adjustments can be tricky to get right.
As you evaluate a deal, keep in mind:
- Adjustments are common, but they deserve scrutiny.
- Documentation and transparency are key. If an addback can’t be substantiated, it shouldn’t count.
- The stakes are high: In some cases, inflated adjustments can distort valuations by millions.
Whether you’re on the buy side or preparing for your own exit, getting EBITDA adjustments right can lead you to a great deal instead of a costly setback.
Interested in expert support as you review deals or prepare your own financials? At 5th Line, we specialize in clarifying the numbers to keep your team informed and your decisions strategic.
Get in touch with us to learn how we can support your next transaction.