Pro Forma EBITDA: a Worked Example

Consolidated accounts include a bought business only from the date control passes. A group that completes an acquisition four months before its year end reports twelve months of its own earnings and four of the target's, while its balance sheet already holds every dollar borrowed to pay for it. Leverage measured on those accounts compares a full year's debt with a partial year's earnings, and looks worse than the business the lender has just financed. A sale works the other way: the debt falls when the proceeds repay it, but the sold business's earnings stay in the trailing figure until a full year has passed.

Accounting goes part of the way. Groups reporting under full IFRS, as adopted in New Zealand, Australia and the UK, disclose the combined group's revenue and profit for the year as though each acquisition had happened at the start of it. That is profit, not EBITDA, and it covers the financial year rather than a covenant's test period. Many mid-market borrowers do not give it at all: Tier 2 reduced-disclosure accounts in New Zealand and simplified-disclosure accounts in Australia are exempt, and UK groups reporting under FRS 102 disclose only the acquired business's revenue and profit since the acquisition date. So the lender usually builds the figure itself, from the target's own records.

The second line is the one a lender checks hardest. It comes from the target's management accounts or a due diligence report, not from the group's audited figures, and it belongs to a business that was run by someone else for most of the period. The fourth line is an ordinary adjustment of the group's own history. The last line is different in kind: savings from closing a site or merging two finance teams that have not yet happened, or have happened only for part of the period. Facility agreements that allow them commonly ask that the actions be identified, be taken or expected within a set time, and be certified by an officer, and many cap the amount. Agreements commonly apply the same basis to interest, and to debt where a test is run on the day of a transaction, so the new borrowing is counted and any debt the deal repaid is treated as gone from the start of the period.

An industrial cleaning contractor, constructed for this page like every figure in it, buys a smaller rival that completes on 1 December. Its year and its test period both end on 31 March. Net debt after the deal is US$60m. The cap on synergies, 10% of pro forma EBITDA before synergies, belongs to the example and is not offered as a market norm.

The first ratio is the misleading one: a business that has not had a full year to earn on its debt. The second is the business the bank lent to, and its integrity rests on the US$2.8m from the target's own accounts, which the lender ties back to that business's bank statements and tax returns before it relies on it. The third adds a forecast. The US$0.2m the cap kept out is small here; the US$1.8m it let in is three-tenths of a turn of leverage that depends on a depot closing and two payrolls merging on time. In this file the lender sizes the debt on the second ratio, and the synergies affect only the headroom the covenant shows.

Adjusted EBITDA corrects the figures of the business that reported them: the deal costs above are that kind of item. Run-rate EBITDA takes a recent month or quarter and treats it as the new normal, which suits a business that has just changed its prices or won a contract. Pro forma EBITDA changes the boundary of what is being measured. The three are often stacked in one covenant definition, and a lender separates them when reading a compliance certificate, because each rests on different evidence: the first on the books, the second on whether the recent period will last, the third on another company's records.

The base period matters too. Pro forma figures are usually built on LTM EBITDA, the last twelve months, so the adjustment for an acquisition falls away by itself once the business has been owned for a full test period. A synergy add-back has its own clock, set by the agreement, and the add-back cap is where the lender limits how far a forecast can stand in for results.

DEFINED IN ONE PARAGRAPH → · DEBT TO EBITDA → · THE ADD-BACK CAP →

It decides the size of an acquisition loan. The buyer's adviser presents a pro forma figure with synergies included, and the lender rebuilds it in layers so that its credit committee can see how much of the debt rests on each. The negotiation that follows is about the last layer: which savings count, how long the borrower has to deliver them, who certifies them, and the cap. It is also about the definition of an acquisition the borrower may make later without asking, because each one brings its own pro forma adjustment into the covenant.

It decides the first test dates after completion. Without a pro forma clause, a covenant set for the combined group can be breached by the accounts alone. With a generous one, a weak quarter can be covered by savings that have not arrived. A lender who tests the forecast commonly runs the group without the synergies as well, so that the committee paper shows how much of the debt service rests on savings that have not yet arrived.

LOAN COVENANTS, EXPLAINED → · QUALITY OF EARNINGS →