When valuing a business, the reported EBITDA is just a starting point. It tells you what the company earned according to accounting rules, but it doesn't always reflect the true, ongoing profitability. Financial statements can be noisy, filled with one-off events and owner-specific decisions that distort the picture. To get to a defensible valuation, we first need to 'normalize' or 'scrub' the EBITDA.

This process involves adjusting the reported figures to remove these distortions. The goal is to calculate a sustainable earnings figure that represents the business's core operational performance. This Normalized EBITDA becomes the clean foundation for any valuation method you use, whether it's a discounted cash flow (DCF), comparable company analysis, or precedent transactions.

The first step is to separate recurring items from non-recurring ones. Recurring expenses are the predictable, ongoing costs of doing business, like salaries, utilities, and marketing budgets. Non-recurring items are unusual or infrequent events that aren't part of normal operations. Since they aren't expected to happen again, they should be added back to EBITDA to avoid unfairly penalizing the company's earnings power.

Common examples of non-recurring costs that are typically added back include:

• Litigation settlements: Legal costs from a specific, resolved lawsuit.
• Restructuring charges: Costs associated with a major corporate reorganization, like closing a plant or a significant layoff event.
• Asset write-downs: A large, one-time reduction in the book value of an asset.
• Gains or losses on asset sales: Profits or losses from selling a building or a subsidiary that isn't part of the core business activity.
• Major repairs from an unexpected event: Costs to fix damage from a fire or natural disaster, which would likely be covered by insurance but can distort expense reports.

Private companies often have expenses that are influenced by the owner's personal decisions rather than the market. Two major areas require careful adjustment: owner compensation and related-party transactions.

An owner might pay themselves a salary of $250,000, but the market rate for a CEO of a similar-sized company in that industry might be $150,000. In this case, the owner is effectively taking an extra $100,000 in salary instead of as profit. To normalize EBITDA, you would add back this $100,000 difference. Conversely, if the owner pays themselves a below-market salary to reinvest in the business, you would subtract the difference to reflect the true cost of that role.

Similarly, related-party transactions need scrutiny. A common example is when the business rents its office from a separate real estate company owned by the same person. The rent being paid might be higher or lower than the market rate. You must determine the fair market rent for a comparable property and adjust the rent expense on the income statement up or down to match. This ensures the company's rental expense reflects a true, arm's-length cost.

Finally, you must identify any personal expenses run through the company. These discretionary costs, like a personal car lease or family travel disguised as a business trip, are not legitimate business expenses. They should be identified and added back to EBITDA in full. This process can require some detective work, but it's essential for arriving at an accurate picture of the company's profitability.

Let's walk through a simplified example. A small consulting firm reports an EBITDA of $500,000. During your analysis, you uncover the following:

Now, let's calculate the Normalized EBITDA.

By making these adjustments, we have a much more accurate and defensible measure of the company's true earning power. This $650,000 figure, not the initial $500,000, is the number you would use to apply a valuation multiple or as the starting point for a DCF analysis.

This discipline of scrubbing financial statements is a critical skill in finance. It separates surface-level analysis from a deep, fundamental understanding of a company's value.