What is Adjusted EBITDA Margin?
The Adjusted EBITDA Margin (%) measures the core operating profitability of a company on a normalized basis, i.e. inclusive of only items related to core business activities.
How to Calculate Adjusted EBITDA Margin (Step-by-Step)
- Adjusted EBITDA → The adjusted EBITDA metric is a non-GAAP, yet widely used, measure of profitability and the operating performance of a company.
- Net Revenue → The revenue of a company refers to the total monetary value generated by a company from its operating activities, i.e. the sale of products and services, net of any discounts, refunds, and sales allowances.
At the most basic level, the traditional calculation of EBITDA comprises adding depreciation and amortization to EBIT, which is otherwise known as “operating income”. D&A is an add-back on the cash flow statement as well as for free cash flow calculations (e.g. FCFF, FCFE) since no actual movement of cash occurred.
The movement from EBITDA to adjusted EBITDA is where most of the discrepancies and differences in opinion arise. EBITDA is a non-GAAP metric, so the adjusted EBITDA metric expands the room for management discretion (and the risk of inflated earnings) even further.
Adjusted EBITDA Margin Formula
The formula to calculate the adjusted EBITDA margin is as follows.
There is no standardized approach to calculating the adjusted EBITDA metric, which is the source of much criticism, as mentioned earlier.
Examples of Normalizing Adjustments
In general, the most commonly accepted add-backs with relatively minimal push-back are the following:
- Owner Salary and Benefits → The salary earned by the management team pre-acquisition—even if the same management continues to run the company—might be adjusted downward to be closer to the market rate. Therefore, the “excess” compensation and benefits are removed to more accurately portray the financial state of the company post-acquisition (or integration if the acquirer is a strategic buyer rather than a financial buyer).
- Owner Expenses: If the management team spent company funds to cover personal expenses and one-time events, those expenses could be added back. However, the assumption here is that those expenses will not continue into the foreseeable future, i.e. they are one-time events.
- Rent: The company might currently be paying less than or above the standard market rent, which might warrant an adjustment to its fair value for bookkeeping purposes. In other words, the historical rent prices can be adjusted to be closer to the current market rate.
- Understaffing: The new owner might identify gaps in the company’s employee base. The issue of understaffing is that it is more subjective, which makes it more challenging to negotiate. In fact, the acquirer would likely need a valid case that the understaffing was either deliberate to reduce spending and improve profit margins or was the result of poor management decisions (i.e. relative to the norm among industry comparables).
- One-Time Fees: Usually, the fees paid to third parties, such as lawyers, consultants, and investment banks—assuming that such services received are one-time expenses—are added back to EBITDA.
- Asset Impairment: If the fair value of an asset, such as inventory or PP&E, declines below the value recorded for bookkeeping purposes, the company can write down the value to more accurately reflect the current value of the asset. Alternatively, if the fair value is zero (i.e. accidental fire-damaged inventory), the value of the asset must be subsequently written-off to provide the highest level of transparency to investors and the general public.