EBITDA and normalized earnings: comprehending and applying to M&A processes
Earnings Before Interest, Taxes, Depreciation & Amortization
(+)Taxes* = Corporate income taxes
(=) Earnings Before Taxes (EBT)
(+) Interest** = Interest paid (received)
(=) Earnings Before Interest and Taxes (EBIT)
(+) Depreciation & Amortization
(=) Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA)
*Corporate income taxes (in Brazil IRPJ and CSLL).
**Interest incurred on debt and interest received on financial investments (excess cash).
Importance and Use of Metrics:
EBITDA is an important and widespread metric in the market because it presents the gross operating cash generation of a company without the influence of factors such as the financial leverage profile (that is, the volume of debts deducted from the cash held in the company), the level of Taxes on capital gains (in Brazil, IRPJ and CSLL) and depreciation and amortization expenses. This allows a more adequate comparability of distinct companies and thereby it is very common as a reference metric in the M & A process (merger and acquisition).
It is also quite usual for EBITDA multiples to be established as a reference for the acquisition price, even if the buyer’s economic and financial analysis is more complex and considers, for the post-acquisition operating reality of the company, other financial elements not present in the calculation of the EBITDA. EBITDA, as well as the investments in fixed assets and working capital required by the company.
Note: companies should take care to not to confuse EBITDA with net cash generation, which is lower than the same and is one of the determining metrics in the intrinsic value determination process of the company, as well with the expectation of growth and the risk of the business.
Normalization of Profit/Loss:
When EBITDA is used as a benchmark for price analysis and pricing in an M & E process, it is used against the concept called standardized EBITDA. The same applies to any other result metrics that will be used by the buyer in the definition of an offer linked to the company’s historical result.
The concept of normalization of results is important so that adequate references are available to the company’s ability to generate operating results under normal operating conditions, such as those projected after a possible transaction.
Thus, non-operating, tax-oriented or non-recurring events are likely to characterize adjustments, according to this illustrative listing below.
Expenditure increase common to the standardization process (worsening outcome):
– Specific and unusual sales the nature of the business;
– Application of accounting policy inconsistently with resultant gain;
– Capitalized (activated) rather than expensed expenses;
– Transactions with related parties that generated undue gains for the activity;
– Transactions not recorded in the accounts for any reason;
– Inadequate reversals of provisions;
– Remuneration below market or distorted by dividend distribution and interest on shareholders’ equity.
Cost decrease common to the standardization process (improvement of the result):
– Personal / non-business expenses / excess remuneration;
– Application of accounting policy inconsistently with loss resulting;
– Expenses with systems implementation;
– Extraordinary expenses with lawyers or lawsuits;
– Transactions with related parties that caused undue losses to the activity;
– Restructuring costs;
– Excess provisions;
– Expenses posted to reduce IRPJ and CSLL that should have been activated.