Adjusted EBITDA: a Worked Example

EBITDA sets the leverage ratio, the debt a business is thought able to carry, and often the covenant it will be tested on. An adjustment is therefore an argument about capacity. The argument can be sound. If a business paid a large settlement on a single claim, last year's earnings understate the next one, and a lender who ignored that would lend too little. The aim is the earnings the business can be expected to repeat, and an honest version moves in both directions.

Outside the listed world, little polices the figure. In a private company's lending pack it is a schedule prepared by management. Regulators do address it for issuers: New Zealand's Financial Markets Authority and Australia's ASIC have published guidance on disclosing such measures, the UK's Financial Reporting Council has reviewed how listed companies use them, and IFRS 18, for annual periods beginning on or after 1 January 2027 where it has been adopted, brings certain measures used in public communications into the notes. A mid-market borrower with no public communications is largely outside all of this, so the lender supplies the discipline itself.

Each line gets the same questions. Is it real, with an invoice or a contract behind it? Has anything like it appeared before? Did the cost stop, or is it continuing under a new label? Is there a matching gain the list has left out? Provisions released, insurance receipts, profits on selling a property and supplier rebates booked early all lift reported earnings, and a list containing only costs is one-sided. New Zealand's regulator makes the same points to issuers: restructuring costs generally recur over the life of a business, and an exclusion of non-recurring items should take out gains as well as charges.

Forward-looking lines belong to a different argument. Cost savings not yet made are run-rate EBITDA, and earnings of a business just bought are pro forma EBITDA. And removing a cost from earnings does not return the cash: the settlement was still paid, so a lender reads liquidity separately. Issue 07 shows the adjustment running the other way, where a retailer's profit was lifted by items that will not come again.

DEFINED IN ONE PARAGRAPH → · ISSUE 07 · QUALITY OF EARNINGS →

A regional chain of hardware stores, constructed for this page like every figure in it, has net debt of US$35m and reports EBITDA of US$8.0m. Its presentation to lenders shows US$11.7m. The lender goes through the bridge and asks for the same lines for the two earlier years.

The chain's list is not dishonest. Each line has a story. But closures in three straight years are part of running a chain of stores, and opening costs recur for as long as it keeps opening. The founder's pay is accepted only because a signed contract changes it (owner remuneration); had the plan been to reduce it later, the line would have gone. The lender's result sits much nearer the accounts than the presentation. Each level here is the example's, not a market norm.

Reported EBITDA is arithmetic on the accounts, though it too is undefined by the main accounting frameworks. Adjusted EBITDA is that figure after management's or a reviewer's changes. Quality of earnings is the wider work of testing whether profit is cash and will repeat; a good adjusted figure is one output of it. Covenant EBITDA is a third thing: the definition written into the facility agreement, which may allow some adjustments, cap others (add-back cap) and freeze the accounting basis.

So one borrower may have three numbers in the same year: the one in the presentation, the one the credit paper uses and the one the compliance certificate tests. A reader should know which is in front of them.

It decides the size of the loan first. At the same multiple of earnings, US$11.7m supports nearly 38% more debt than US$8.5m. It then decides the covenant. A borrower who wins a wide definition can show compliance while reported earnings fall, so the definition is often the most negotiated part of the financial covenants, and in a sponsor-backed deal more add-backs tend to be permitted than in a bilateral bank facility.

The trend matters as much as the level. A bridge that widens each year, or exceptional items that return under a changed heading, tells a lender how management thinks about its own costs. A borrower near a limit does better to bring the bridge three years deep, with the evidence attached, than to defend it line by line afterwards.

WORK THE SUM · THE NUMBER → · EXCEPTIONAL ITEMS → · DEBT TO EBITDA →