Add backs

What Are Add backs?

Add backs are specific adjustments made to a company's reported earnings, usually to present a more normalized or representative view of its ongoing operational profitability. These adjustments are a common practice in corporate finance, particularly within mergers and acquisitions (M&A) and business valuation, as they aim to remove the impact of non-recurring, discretionary, or non-operating expenses from financial results. The goal of add backs is to arrive at a truer picture of a business's capacity to generate sustainable cash flow and earnings, making it easier to compare with other entities or evaluate its standalone performance. For instance, when calculating a company's EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), certain expenses might be "added back" to reflect a prospective buyer's future operational costs, excluding items specific to the current owner or one-time events.

History and Origin

While the specific term "add backs" may not have a singular, documented origin, the practice of adjusting financial results for analytical purposes has long been ingrained in financial analysis and due diligence. The need for such adjustments arose as financial statements prepared under traditional accrual accounting principles, such as Generally Accepted Accounting Principles (GAAP), primarily focus on historical performance and compliance rather than predictive operational capacity. In the context of business sales and investments, particularly in private equity, buyers and investors sought to understand a business's true earning power independent of non-core activities or owner-specific expenses. This led to the widespread adoption of "pro forma" adjustments, with add backs becoming a critical component of this analytical process. The U.S. Securities and Exchange Commission (SEC) has provided guidance on the use of non-GAAP financial measures, which include many forms of add backs, to ensure transparency and prevent misleading presentations, reflecting the evolution and formalization of these practices in public reporting.¹⁸

Key Takeaways

Add backs are adjustments made to a company's reported earnings to reflect a normalized view of its operational performance.
They typically involve adding back non-recurring, non-operating, or discretionary expenses to core earnings metrics.
The primary purpose is to provide a more accurate assessment of a company's sustainable cash flow and profitability for valuation or comparative analysis.
Commonly used in M&A transactions, business sales, and financial modeling.
While useful, add backs require careful scrutiny to ensure they are legitimate and not used to inflate perceived performance.

Interpreting Add backs

Interpreting add backs requires a clear understanding of why each adjustment is being made and its impact on the underlying financial metric. When analysts or potential buyers review a company's income statement, they typically start with reported net income and then make a series of adjustments to arrive at an "adjusted" or "normalized" earnings figure, often EBITDA. For example, if a business owner paid themselves an unusually high salary or funded personal expenses through the company, these would be considered owner-specific add backs. Similarly, one-time legal fees or significant, non-recurring consulting expenses could be added back to present a clearer picture of ongoing operations. The objective is to strip away items that are unlikely to continue post-acquisition or are not representative of the core business's performance, thereby providing a more relevant basis for discounted cash flow models or multiple-based valuations.

Hypothetical Example

Consider "Tech Solutions Inc.," a small software company being evaluated for acquisition. In the past year, its financial statements show a net income of $500,000. However, a closer look during due diligence reveals several items that could be treated as add backs:

Owner's Discretionary Expenses: The founder, who plans to retire, expensed $75,000 for a luxury car and country club membership, which will not be part of the company's expenses post-acquisition.
One-Time Legal Settlement: Tech Solutions Inc. paid $100,000 for a settlement related to an old patent dispute, an expense not expected to recur.
Non-Recurring Severance Costs: Due to a strategic reorganization last year, the company incurred $50,000 in severance payments.

To calculate the "adjusted EBITDA" or "normalized earnings" for valuation purposes, these add backs would be factored in. Assuming Tech Solutions Inc. had a reported EBITDA of $800,000 before these adjustments, the calculation would be:

Original EBITDA: $800,000
Add: Owner's Discretionary Expenses: $75,000
Add: One-Time Legal Settlement: $100,000
Add: Non-Recurring Severance Costs: $50,000
Adjusted EBITDA: $800,000 + $75,000 + $100,000 + $50,000 = $1,025,000

This adjusted figure of $1,025,000 provides a more accurate representation of the company's underlying operational profitability, allowing potential buyers to better assess its value based on its ongoing earning potential.

Practical Applications

Add backs are widely applied in several financial contexts to refine the analysis of a company's financial health. They are particularly prevalent in:

Mergers and Acquisitions (M&A): During M&A transactions, buyers use add backs to normalize the target company's earnings, presenting a clearer view of its standalone profitability and potential synergies. This helps determine a fair purchase price and facilitates comparing the target with industry benchmarks or other potential acquisitions. The due diligence process often focuses on identifying these adjustments to challenge assumptions about future performance.¹⁷
Business Valuation: For both public and private companies, add backs are crucial in deriving normalized earnings multiples for valuation models. Whether using a multiple of EBITDA or applying a discounted cash flow approach, the integrity of the underlying earnings figure is paramount.
Lending and Financing: Lenders often analyze a borrower's financial statements with add backs to assess the true capacity for debt repayment, looking beyond one-off expenses that might artificially depress current earnings.
Financial Modeling and Forecasting: Analysts use add backs to build more accurate financial models and create realistic future earnings per share or cash flow projections by removing historical anomalies.

Limitations and Criticisms

Despite their utility, add backs are not without limitations and have faced criticism, primarily regarding their potential for misuse. One major concern is the subjective nature of what constitutes a "non-recurring" or "non-operating" expense. Companies may be incentivized to classify certain legitimate, recurring operating expenses as add backs to inflate reported adjusted earnings, thereby presenting a more favorable financial picture than reality. The SEC has cautioned against using non-GAAP measures, including add backs, in a misleading manner, particularly if they exclude normal, recurring, cash operating expenses necessary to operate a business.¹⁶ Such practices can distort investment decisions and lead to an overvaluation of a company.¹⁵

Critics argue that an excessive reliance on add backs can obscure a company's true financial health by distancing reported performance from the actual figures on its balance sheet. The Federal Reserve Bank of San Francisco has noted the proliferation of non-GAAP metrics, emphasizing the need for investors to understand the implications of these adjustments.¹⁴ Furthermore, consistency is key; inconsistent application of add backs across different periods or compared to industry peers can make financial analysis difficult and unreliable. While add backs are intended to provide clarity, their subjective application can sometimes introduce opacity, warranting careful scrutiny from investors and analysts.¹³

Add backs vs. Pro Forma Adjustments

While the terms "add backs" and "pro forma adjustments" are often used interchangeably in practice, "add backs" represent a specific type of pro forma adjustment.

Add backs specifically refer to expenses (or sometimes revenues) that are added back to a company's earnings to arrive at a normalized or adjusted figure. These are typically non-recurring, discretionary, or non-operating items that are not expected to continue in the future operations of the business or are specific to the current ownership structure. Examples include one-time legal fees, owner's excessive salaries, or extraordinary expenses.
Pro Forma Adjustments is a broader term encompassing any adjustments made to historical financial statements to reflect a hypothetical scenario or expected future state. This can include not only add backs but also adjustments for cost synergies in an acquisition, changes in capital expenditures, modifications to working capital requirements, or the impact of discontinued operations. Pro forma statements aim to show what the financials would have looked like under different circumstances, while add backs are specifically about normalizing historical earnings.

In essence, all add backs are pro forma adjustments, but not all pro forma adjustments are add backs. Pro forma adjustments provide a comprehensive view of how a company's financials might change under various assumptions, whereas add backs focus on normalizing historical earnings by removing specific expense items.

FAQs

What types of expenses are typically considered add backs?

Common add backs include one-time legal settlements, non-recurring consulting fees, owner's discretionary expenses (e.g., personal car or travel expensed through the company), extraordinary repairs, severance costs from a one-off restructuring, and certain non-cash expenses like non-cash rent or depreciation (when adjusting to EBITDA). The key is that these expenses are not expected to recur in the ordinary course of business.

Why are add backs important in business valuation?

Add backs are crucial in business valuation because they help prospective buyers or investors understand the true, sustainable earning power of a company. By removing non-recurring or owner-specific expenses, the adjusted earnings provide a clearer picture of the operational profitability that a new owner could expect, allowing for more accurate comparisons and a more realistic assessment of the business's worth.

Can add backs be misleading?

Yes, add backs can be misleading if not applied judiciously. If a company repeatedly classifies recurring operating expenses as "one-time" or "non-recurring" to inflate its adjusted earnings, it can create a distorted and overly optimistic view of its financial performance. Regulatory bodies like the SEC monitor such practices to ensure transparency in financial reporting.¹² Investors and analysts must scrutinize add backs carefully to determine their legitimacy and impact on a company's actual profitability.

Are add backs used in public company financial reporting?

While public companies generally adhere to GAAP (or IFRS), they often present "non-GAAP financial measures" in addition to their official financial statements. Many of these non-GAAP measures, such as "Adjusted EBITDA" or "Core Earnings," involve adjustments akin to add backs. However, public companies are subject to strict SEC rules requiring clear reconciliation of non-GAAP measures to their most directly comparable GAAP measures and prohibiting misleading presentations.¹¹

How do add backs impact a company's sale price?

Add backs can significantly impact a company's sale price, especially in privately held businesses. A higher adjusted earnings figure, derived after applying legitimate add backs, often translates to a higher valuation multiple (e.g., a multiple of adjusted EBITDA). This is because buyers are willing to pay more for a business that demonstrates stronger, more consistent underlying operational profitability without the noise of non-recurring or owner-specific expenses.¹ ² ³ ⁴ ⁵, ⁶ ⁷ ⁸, ⁹ ¹⁰