Crash Course on Add Backs

 

Add-backs are commonly used in the language of business valuations to determine the true profitability of a business. Put simply, add-backs are expenses already deducted from the revenues as shown in the income statement and are added back because they are not part of the company’s revenue-generating activities.

Identifying Add Backs

A business broker has an important role in identifying add-backs to determine the right multiple for valuing a business for sale. To identify add-backs, a review of the financial statements such as the Income Statement, Cash Flow Statement, and Balance Sheet, is an important step as well as understanding the operations of the business and the related operating expenses.

What Are Add Backs

The identified add-backs in determining the EBITDA differ depending on the type of business and the end goal needed. Let’s look at these add-backs below:

What are add-backs in accounting?

The common add-backs in accounting refer to non-cash expenses such as depreciation and amortization, financing costs such as interest expenses, tax returns, non-recurring or extraordinary expenses, personal expenses of the owner, and other discretionary expenses.

These expenses are added back to determine the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). The formula of EBITDA is shown below:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

What are add-backs in business?

Potential buyers are interested to know what the real profitability of the business is. This will help them evaluate whether the business is a sound investment and its potential for future generation of cash flow.

These add-backs in businesses are necessary for business valuation, M&A advisory, or simply to provide an accurate picture of the financial statements of the company. 

What are add-backs in business valuation?

In terms of valuation, expense items that are added back have the following characteristics:

• Non-operational
• Non-cash
• Discretionary

The common add-backs include the owner’s expenses such as owner compensation that is above the industry average for the type of role played in the business, depreciation and amortization expenses, one-time and non-recurring expenses, discretionary spending, and extraordinary items.

Justifying Add Backs

Buyers will need the justification during the valuation process of why certain items are added back in the valuation that caused the increase in the valuation multiple.

So what are add-backs when selling a business and how are they justified? Below are the common examples of expenses that are added back and how they are documented in the presentation of the business and its valuation when selling your business:

1. One-time Expenses – This refers to non-recurring items that are not usually spent in the operations of the business. To justify this, it has to be documented properly. For example, legal expenses amounting to $150,000 due to a dispute in one of the software developed by the company.
    
2. Owner’s Personal Expenses – When it comes to sole proprietorships and family businesses, personal expenses cannot be completely avoided. Examples of this include travel and fuel expenses. Documents and receipts need to be presented to justify adding back this expense.
    
3. Owner Compensation – It is not unusual when a family member who works in the business earns more than the industry average for that role. In this case, benchmarking against the industry standard needs to be done.
    
4. Non-operational Expense – There are instances when a company makes acquisitions that are related to the business but unrelated to its operations. For example, when a company decides to relocate and incurs relocation expenses. Having a clear classification of operational expenses from non-operational expenses will help a business owner justify the add-back.

What is most important here is providing proper documentation to present as evidence in the presentation of the business valuation.

Common Add-Back Examples

What are examples of add-backs and where do you find them in the financial statements?

The types of add-backs are generally found in the income statement because these are usually items that are used to compute the EBITDA. Here are the common examples:

• Owner Expenses: Compensation above industry benchmark, personal travel expenses, automobile expenses.
• One-time Expenses: Restructuring expenses, relocation costs, legal expenses, and expenses incurred due to natural disasters. 
• Non-Cash Expenses: Depreciation, amortization, stock options issuance to employees. 
• Charitable donations. 
• Financing Costs: Interest expenses, debt refinancing expenses. 
• Related-party Expenses. 
• Legal Fees.

Importance of Add Backs in M&A

In the process of closing a transaction in Mergers & Acquisitions, presenting an accurate financial health of the business is important. So what are add-backs in a deal relating to M&A?

Anything discretionary, non-operating, non-recurring, and non-cash are considered add-backs to M&A dealings. These are important for the business to present its true potential for profitability and sustainability.

What Are Add-Backs In Tax?

The add-backs in taxation are also important for the business to show the real taxable income of the business. This means that tax returns and financial statements support and show the transparency of the taxable income.

What Are Add-Backs To EBITDA?

What are EBITDA add-backs? These are the expense items shown in the income statement:

• Interest Expense
• Tax Expense
• Depreciation Expense
• Amortization Expense

EBITDA is an important computation for valuation purposes and shows only the profitability of the company based on its core operations.

What are Valuation Add-Backs?

A business owner often asks during the valuation process what are typical add-backs that could influence the valuation multiple in selling their business. These are expenses that affect the real presentation of the company’s profitability. They include non-recurring, non-operating, non-cash, and extraordinary expenses.

With a documented, accurate, and justified process of adding back these expenses, a buyer and seller can mutually agree on the selling price of a business.