What Is Normalized EBITDA and How Is It Calculated?

In Summary:

• Definition and Purpose: Normalized EBITDA (or Adjusted EBITDA) is a financial metric used to reveal a company’s “true” earning power by removing one-time, discretionary, or non-market expenses. It helps potential buyers understand the recurring, sustainable earnings they can realistically expect under new ownership.
• The Calculation Process: To calculate it, you start with standard EBITDA (Net Income + Interest, Taxes, Depreciation, and Amortization) and then add back or subtract adjustments. Common adjustments include removing one-time legal fees, personal owner expenses (like vehicles or travel), and non-essential perks.
• Impact on Valuation: Because business valuations are typically based on a multiple of EBITDA, normalization directly affects the final sale price. However, these adjustments must be well-documented and defensible, as they are heavily scrutinized by lenders and buyers during the due diligence process.

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When evaluating a business’s true earning power, it’s not enough to look at standard financial statements alone. Many companies have expenses or income items that are unusual, personal, or unlikely to continue under new ownership. That’s where Normalized EBITDA becomes an essential tool in business valuation. By adjusting EBITDA to remove one-time costs, discretionary spending, and related-party distortions, normalized EBITDA provides a clearer picture of the company’s sustainable operating performance and the earnings a buyer can realistically expect.

In most lower-middle-market transactions, valuation multiples are applied to adjusted EBITDA rather than reported earnings. As a result, how EBITDA is normalized often has a direct and material impact on value.

What Is Normalized EBITDA?

Normalized EBITDA, sometimes referred to as Adjusted EBITDA, reflects the revenues and expenses that would reasonably continue under hypothetical new ownership. The goal is to isolate recurring, economically transferable earnings. When normalizing EBITDA, you’re effectively replacing the owner with a rational business operator to ask:

• Is this expense necessary to operate the business?
• Would this cost exist under independent ownership?
• Does this transaction reflect fair market value terms?

Common categories of earnings distortions include:

• Owner compensation
• Related party rent or supply arrangements
• One-time professional fees or consulting costs
• Discretionary spending and personal expenses
• Non-essential employee benefits
• Timing anomalies in cyclical expenses like repairs and maintenance

How to Calculate Normalized EBITDA

The formula for Normalized EBITDA can be summarized as: Normalized EBITDA = EBITDA + Upward Adjustments − Downward Adjustments

While adjustments often increase EBITDA, normalization can also reduce earnings when costs are below market levels.

1. Calculate Standard EBITDA

Start with the net income of the business. Then, add back interest, taxes, depreciation, and amortization:

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

2. Adjust for Non-Recurring Expenses

Identify and add back any one-time expenses that do not reflect the ongoing operations of the business. These may include:

• Unusual repairs or capital catch-up expenses: If a company incurred $100,000 of maintenance in one year but historically averages $30,000 annually, EBITDA may be adjusted upward by $70,000 to reflect normalized spending levels.
• Transaction or restructuring costs: Legal, accounting, consulting, or restructuring expenses tied to ownership changes or unusual events are typically removed from normalized EBITDA.

3. Adjust for Discretionary Expenses

Add back discretionary expenses that are not essential for the business’s core operations. These might include:

• Charitable donations: While a potential owner may still make charitable contributions, they could take a contribution for the donation rather than having it come straight from the business.
• Owner’s personal expenses: Any discretionary expenses the owner incurs that aren’t related to the company should be added back to earnings. This might include meals and travel unrelated to the business, or sporting event tickets the owner uses exclusively (not with clients). Because we don’t expect a hypothetical buyer stepping into the owner’s shoes to pay for these personal expenses, they become additional income available to the owner.
• Non-essential employee perks.
• Personal vehicle and insurance expenses.

4. Adjust for Related-Party Expenses

Items outside market value due to related-party relationships need to be adjusted to reflect their true cost to an unaffiliated party. When normalizing EBITDA, we commonly make adjustments for the following related-party expenses.

Owner’s compensation. Owners decide how much to pay themselves, and their compensation could be above or below market rate. For example, imagine that a CEO is the sole owner of a business and pays themselves $50,000 per year. Based on market data for companies of similar size in the same industry, the market compensation for this position is $200,000. In this case, we’d subtract $150,000 from the company’s EBITDA, assuming that a new owner would need to pay their CEO a market salary.

Rent paid to a related company: If a business leases property from a commonly owned real estate entity, rent is adjusted to market levels to reflect the cost a third-party buyer would incur.

Related business expenses: When goods or services are purchased from affiliated entities at non-market pricing, earnings are adjusted to reflect arm’s length economics. For example, say you also have ownership in two companies: Company A and Company B. Company A supplies Company B with one of the major materials it sells. And because you’re an owner there, you charge yourself below-market rates for your supplies. We’d reduce EBITDA in this instance, assuming that a prospective buyer would need to pay the market rate.

Normalized EBITDA in Business Valuation

Whether you’re preparing a business for sale, assessing an acquisition, or simply gaining insight into financial performance, calculating normalized EBITDA offers a more accurate and market-relevant view of a company’s true value. However, normalization adjustments must be carefully supported and defensible. Buyers, lenders, and their advisors routinely scrutinize each adjustment during financial due diligence. Adjustments without documentation, historical support, or clear economic justification are often rejected, which can reduce perceived earnings and ultimately impact valuation and deal terms.

Developing a well-supported normalization analysis early in the process helps strengthen credibility, reduce transaction risk, and support value expectations. If you have any questions or need assistance, please use the form below to contact us.