Adjusted EBITDA

December 09, 2020

by a searcher from Massachusetts Institute of Technology - MIT Sloan School of Management in Florida, USA

Hello everyone, I am looking at a financial statement for a potential deal and was curious if someone can help.

When evaluating Adjusted EBITDA, particularly for asset heavy businesses like manufacturing, is there anything you should be specifically on the lookout for? Something where the adjustment may not be legit or too small so the earnings are bigger than what they really are?

Example, the depreciation on the machines is added back and deflated or not as high as it should be, which then causes the EBITDA to be inflated leading to a higher purchase price for the seller?

Those types of red flags. What do you keep an eye out for.

Thanks!

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Reply by a lender
from University of Missouri in St. Louis, MO, USA

The EBITDA wouldn't move if the depreciation is understated. That would just impact the net income. With regards to what you could pay attention to in these businesses...focus on the capex. Most of the time in asset heavy businesses that are being sold you will hear that there is more than enough (even excess equipment) and that everything works great. However if you see that maintenance capex and new expenditures decreased over the last 24 months, that could point to some upcoming expenses. You could probably dial it down even further and ask for utilization schedules. Find out which pieces of equipment are getting the most use and see how old they are and what it costs to keep them up and running. You could have the appearance of the equipment on average being new and up to date, but specific pieces that are integral could be aged and require a lot of upkeep after the sale. That will hit your earnings so make sure it is flushed out prior to acquisition.

Reply by a searcher
from University of Virginia in Richmond, VA, USA

I'm not sure I understand your question about deflating depreciation. I'd argue that depreciation in the books and the tax returns will likely differ. So it's hard to figure whether you're getting scammed there. But the easiest way to tell whether depreciation is inflating the ebitda and therefore the asking price is to back into what the capex had been for the last sever years. If the capex is high, there goes much of that wonderful free cash flow.

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