What is EBITDA and how do you calculate it?
SHORT ANSWER
Start with net income, then add back interest, income taxes, depreciation and amortization. Those four items reflect financing choices, tax and accounting write-downs rather than how the business performs, so adding them back shows the profit the business makes from its operations.
Here is a simple example.
| Example | |
|---|---|
| Net income | $400,000 |
| Add: interest | $30,000 |
| Add: income taxes | $60,000 |
| Add: depreciation and amortization | $110,000 |
| EBITDA | $600,000 |
Why do buyers use EBITDA?
SHORT ANSWER
It lets buyers compare businesses on the same footing. Two companies can earn the same from operations but show different net income because one has more debt or older equipment. EBITDA strips those differences out, so the comparison is about the business itself.
Most Canadian mid-market businesses are priced as a multiple of EBITDA. For example, if buyers pay 4x and your EBITDA is $600,000, the starting point is a $2.4 million enterprise value.
The industry sets the starting range, and your business's specific traits decide where you land inside it. Contracted recurring revenue, a broad customer base, low owner dependence and a capable management team move you toward the top. A few customers making up a large share of revenue, declining sales, poor records and a business that runs through you move you toward the bottom.
What is normalized (or adjusted) EBITDA?
SHORT ANSWER
Normalized EBITDA is EBITDA adjusted to show what the business would earn under a new owner. It removes one-time costs and personal expenses run through the company, and it sets the owner's pay at a market rate. This is the number buyers actually price.
The adjustments are called add-backs, and every one needs evidence behind it. Common add-backs include:
- One-time costs: a lawsuit settlement, a one-off consulting project, moving costs.
- Personal expenses: a family vehicle, personal travel or phone bills run through the company.
- Owner pay: if you pay yourself $300,000 and a general manager would cost $150,000, the $150,000 difference can be added back. If you pay yourself less than market, earnings go down instead.
- Non-working family members on payroll.
Add-backs matter because buyers pay a multiple of adjusted earnings. At a 4x multiple, every $50,000 of accepted add-backs adds about $200,000 to the value, and every $50,000 rejected takes the same amount away. For more, see what are add-backs when selling a business.
How do buyers test your EBITDA?
SHORT ANSWER
Through a quality of earnings review. The buyer's accountants match reported revenue to actual bank deposits and trace every add-back to a document. Buyers reject add-backs they can't trace, costs that are likely to repeat, and "one-time" items that show up every year.
Anything unsupported gets removed, and the price falls with it. Some sellers commission their own review before going to market, so surprises become known facts they can explain on their own terms. See why deals lose value in due diligence.
What doesn't EBITDA show?
SHORT ANSWER
EBITDA ignores the cash you'll need to replace equipment, and it doesn't show how much working capital the business ties up. Good buyers look at both. A business with high EBITDA but old equipment will get a lower offer, because the buyer will have to pay for what was put off.
EBITDA times the multiple is enterprise value, which is not what you receive. To get to what lands in your account, debt is repaid, surplus cash is added, working capital is adjusted against an agreed target, and transaction costs come off. The 12-month playbook explains each step.
What this means for you
Know your EBITDA, and know your normalized EBITDA, before anyone else calculates them for you. Then make your add-backs easy to accept:
- Keep a schedule with each add-back, the amount, the year and the reason.
- Attach the invoice, contract or statement behind each one.
- Stop running personal expenses through the business well before a sale.
- Have your CPA review the schedule before any buyer sees it.
You don't need to be planning a sale to benefit. Clean, well-supported earnings make the business stronger whether you sell, grow or hold.
