If you’re in the process of analysing the financial documents of a business you want to buy, or you’re thinking about selling your business, both EBITDA and add-backs are terms you need to know about.
So what exactly have they got to do with assessing a potential acquisition? And how can they help you achieve a higher price for your business when you sell?
Don’t worry, we’ll get to that. First, it’s important to establish a few base points and definitions to help us along the way…
EBITDA is an acronym for “earnings before interest, taxes, depreciation and amortisation”. It is a key metric used to analyse a business’s profitability and plays an important role in estimating the value of a business. If the term EBITDA is new to you then you can learn more about EBITDA in my previous blog post here…
Amortisation & Depreciation
Amortisation and depreciation are both methods used to calculate the value of assets over time. Amortisation tackles intangible assets or loans. While depreciation expenses fixed assets, like buildings and office equipment.
By calculating these expenses a business can use them as a tax deduction. In turn, this reduces the business’s tax liability.
Okay, So What Are Add-Backs?
Add-backs are expenses relative to a seller that may not apply to the new acquirer.
In terms of valuing a business, these should be accounted for and incorporated into any business account review to improve the profits for the purpose of a higher valuation.
Whilst net earnings alone are relevant for accounting purposes, the addition of add-backs provides a fuller picture of the financial state of the business.
This isn’t just beneficial to a seller though, it’s beneficial to the buyer too. Enabling them to get a clear view of both the company’s likely future cash flow and the financial benefits the current business owner experiences.
In addition, sellers remaining transparent around historical financial statements can achieve a better valuation and support a hopefully healthier, stress-free sale.
The Types Of Add-Backs
There are quite a few different types of add-backs, and understanding them means you can correctly identify increases to the EBITDA. And remember, accurate EBITDA calculations = accurate valuation of any potential business acquisition.
Three of the most common add-backs to EBITDA are:
- Non-recurring. As the name suggests, non-recurring add-backs are expenses that won’t happen again.
- Discretionary. These are add-backs that tend to exit with a new owner.
- Non-operating. Both discretionary and non-operating add-backs are not related to the operational side of the business. Buildings and vehicles are both examples of non-operating assets that would fall under this category.
An example of a legitimate add-back would be a luxury car for the owner. An example of tax fraud would be having family members contracted on the payroll when they aren’t working for the business.
Some add-backs won’t sit well with a potential buyer. To work out if the add-backs you’re considering adding to EBITDA are legitimate, ask yourself this:
Will the business itself have to fund the add-back once it has changed hands?
If the answer is yes, scrap that add-back.
Tax Avoidance Or Tax Evasion?
Whilst tax planning (a business owner making sure all elements of their business work together to legally allow you to pay the lowest tax possible) is fair – tax avoidance comes under ethical scrutiny.
And beyond that, there’s tax evasion, where a business conceals income or information from HMRC, which is illegal.
There is a fine line between tax avoidance and tax evasion, so you must be scrutinous to ensure what the business is doing sits on the right side.
The Buyer’s Perspective
An accurate EBITDA is what any buyer wants to see. But a buyer who’s done their homework will know that good analysis is necessary to really understand all of the figures.
If a buyer takes over a business in which tax fraud has occurred, anything illegitimate is now their financial responsibility. On this basis, the buyer is perfectly within their right to refuse a deal if any form of evasion is spotted.
Another scenario to consider is a lengthy add-back list. In response, the buyer may want to extend the term over which the seller gets paid. This is often because they want to see how things go in the absence of these figures once the business has changed hands.
Add-Backs Can Increase A Valuation
When selling a business, accuracy is everything. No one likes surprises.
Add-backs get you a higher valuation because they increase the company’s earnings on a normalised basis. But, they should be considered carefully.
Buying and selling businesses can be stressful. Bringing on board the services of a professional to identify and validate all of your add-backs can help give you peace of mind.
Book a call with The Business Consultant and lessen the stress.