EBITDA adjustments are often one of the earliest valuation pressure points in a deal because they directly impact pricing. Since transactions are usually valued in multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), even small changes can greatly affect the valuation.
Adjusted EBITDA is important because it offers a view into a company’s true financial health. It’s a snapshot of a company’s operating profitability. Even though adjusted EBITDA isn’t an official GAAP term, people often use it as a stand-in for operating cash earnings before factoring in things like interest, taxes, depreciation, and amortization.
Sellers, brokers, buyers, and lenders typically have different views of adjusted EBITDA, and that impacts negotiations.
Add-backs are adjustments made to the financial results of a company to create “normalized” EBITDA, which is then used to evaluate and value a company. Not all “add‑backs” will hold up during diligence, though, and early mistakes can become worse later.
Understanding EBITDA Adjustments and Avoiding Common Pitfalls
Sellers and brokers often look at adjusted EBITDA differently than buyers do. They usually present adjusted (or normalized) EBITDA in a way that highlights their business’s strengths and makes it look as appealing as possible. The seller side is focused on what the business could earn under a reasonable owner/operator in a normal year with a few cleanups. They are looking for a “marketable” earnings number.
The reasons for making these adjustments can vary. Sometimes, sellers want to show what the business’s earnings would look like without one-time events or special expenses related to the owner. During due diligence, buyers might find things that actually lower EBITDA or reveal costs the seller didn’t include.
For example, the business might be paying less than market rate rent to a related party, not carrying enough insurance, or putting off necessary upgrades and maintenance. There could also be unfunded pension or benefit obligations. In smaller businesses, owners sometimes mix personal expenses with business expenses, so these need to be taken out to get a true picture of the company’s earnings. And the business might also have one-time items like legal fees, unusual repairs, and nonrecurring events.
Meanwhile, buyers, lenders, and advisors typically view/underwrite adjusted EBITDA as a defensible, repeatable baseline supported by evidence. Buyers must do their due diligence to see how the business actually performs.
For example, what a seller or broker sees as a fair add-back might not be viewed the same way by the buyer or the bank. Lenders are usually cautious, and they’ll only consider adjustments that can be clearly justified and traced back to the company’s financial statements. They often use the most conservative EBITDA definition because it drives debt sizing, covenants, and repayment capacity. In practice, this means banks will lend money based on a multiple of the adjusted EBITDA, but only after removing any add-backs that they don’t believe are truly valid or sustainable.
If an adjustment can’t be backed up with solid evidence or doesn’t reflect the business’s actual ongoing performance, it probably won’t get counted when determining how much financing the buyer can secure. So, while sellers might aim to present their numbers in the best possible light, buyers and lenders will always dig in deeper to make sure those numbers hold up under scrutiny.
For buyers, any adjustments must be evidence-based and tied to the general ledger, payroll, invoices, and contracts. They must also be already realized, meaning not hypothetical cost cuts or best-case outcomes, and they should not be buyer-specific.
The buyer can take steps to ensure the expenses added back do not continue post-closing, like having contractual agreements with the sellers on what compensation and personal expenses will be allowed, if any.
Mapping Adjustments to the General Ledger
Every proposed adjustment should be mapped back to the general ledger, showing where they were originally recorded in the financial statements. This is necessary to understand where the transaction was originally recorded and whether it ran through the P&L (profit and loss statement) or bypassed it entirely.
Watch out for a potential red flag: Adjustments that cannot be clearly traced to accounting records. If it can’t be mapped, it shouldn’t be assumed valid. Only adjustments recorded to the P&L represent potential adjustments to EBTIDA.
Here’s something else to keep in mind: EBITDA is a number that comes from the P&L, not from the balance sheet.
This matters because the balance sheet doesn’t show how much money the business actually made from its day-to-day operations. Just moving cash around doesn’t mean the business is profitable. So, here are a few things that shouldn’t be counted as EBITDA adjustments:
- Changing how items are listed on the balance sheet
- Transactions related to loans or raising money (like getting new investors)
Also, just because cash shows up in a business, that doesn’t automatically mean the company is making money from its operations. Sometimes, cash might come from other sources that don’t reflect how the business is really performing. For example, things like shareholder distributions, loans from owners or related parties, or cash moved between different companies can look like extra money, but they don’t represent true profits from running the business. Sellers might try to highlight these items as a benefit, but be careful. You need to make sure the cash is coming from the business and not just moved around or from outside sources.
Certain transactions can inflate perceived earnings without actually improving operations. It’s crucial to distinguish between what the business generates from normal operations, like selling products or services, and owner-level cash flows, which are things that benefit the owner but don’t reflect business performance.
Cash Flow Reconciliation: What to Watch For
It’s essential to compare EBITDA to actual cash flow. If the numbers don’t match up, that’s a sign that something might be off. For example, if EBITDA goes up but the company isn’t bringing in more cash from its regular operations, that could mean the improved earnings are just on paper, such as from accounting changes or timing differences and not real growth.
By doing this reconciliation, you can also spot when the seller is mixing business performance with personal decisions, like running personal expenses through the company or changing compensation.
Here are the main things to keep an eye on:
- Adjustments that make up a big portion of total EBITDA. This could be a sign that reported earnings might not accurately show the company’s performance.
- “One-time” items that appear every year.
- Adjustments that aren’t backed up by documents or clear accounting.
- Savings that are not implemented, with no executed plan or payroll actions.
- Operational improvements that have not yet been executed.
- Costs that are taken off the profit and loss statement, but the actual expense doesn’t go away. This could mean expenses are being moved around.
- Double counting. Capitalizing expenses to lift EBITDA while also understating ongoing capital expenditures.
How Buyers Should Use EBITDA Adjustments in Early Deal Stages
When you’re just starting a deal, it’s smart to treat the seller’s EBITDA adjustments as a starting point and avoid rushing to lock in a valuation on their numbers. Due diligence is crucial before anchoring a valuation.
It’s helpful to keep track of all versions of EBITDA: what’s reported, what the seller has adjusted, and your own view as a buyer. Seeing all three side by side helps you spot where the numbers might not tell the full story.
Early discipline around EBITDA adjustments saves a lot of headaches later. Getting this right up front makes you look more credible when negotiating and lowers the chances of last-minute disagreements or surprises.
Engaging transaction advisory services early in the deal process can make a major difference. Experienced advisors help you navigate adjustments, offer insights, and keep your valuation grounded in reality. By partnering with professionals from the start, you position your business for a smoother transaction and more long-term success.