What Are Add Backs and How Are They Used?

Add backs adjust a company’s financial figures to show its true operational performance and cash flow. They identify and reverse expenses or income items that don’t reflect core business activities. By normalizing financial statements, add backs provide a more accurate view of a company’s sustainable profitability. This adjusted perspective is useful for analysis and understanding a business’s intrinsic value.

Understanding Financial Statement Adjustments

Financial statements, such as the income statement, are prepared following generally accepted accounting principles (GAAP), which aim for consistency and comparability across various entities. While these principles provide a standardized view, they often include expenses or non-cash items that can obscure a company’s core, ongoing operational performance. For instance, depreciation expense is a non-cash allocation of an asset’s cost over its useful life, reducing reported profit without a direct outflow of cash in the current period. A business might also incur a significant, one-time legal expense or a large, unusual repair that distorts its typical annual profitability.

Add backs normalize reported figures for analytical purposes. They strip away the impact of non-operational, non-recurring, or non-cash items. This allows analysts to focus on profitability generated from the business’s primary activities. By reversing these items, adjusted financial statements offer a more precise measure of a business’s true cash-generating ability and sustainable earning power.

Common Types of Add Backs

Owner’s Salary and Personal Expenses

Owner’s salary and personal expenses are a common add back. In smaller, privately held businesses, owners might pay themselves an inconsistent salary or run personal expenses through the business. These expenditures do not reflect the fair market value of the owner’s labor or typical operational costs for a new, non-owner manager. Therefore, to assess the business’s true profitability, these disproportionate or personal expenses are added back to reported earnings.

Non-Recurring or One-Time Expenses

Non-recurring or one-time expenses are another category. These are costs unusual and not expected to repeat in normal business operations. Examples include substantial legal fees from a lawsuit, large one-off repairs, or expenses from a discontinued product line. Adding them back provides a clearer picture of the business’s sustainable earning capacity without the distortion of an anomalous event.

Depreciation and Amortization

Depreciation and amortization are added back as non-cash expenses. Depreciation allocates the cost of tangible assets, like machinery or buildings, over their useful lives. Amortization does the same for intangible assets, such as patents or copyrights. Although they reduce reported net income, they do not involve a current outflow of cash, so they are added back to reflect actual cash generated by the business.

Interest Expense and Tax Expense

Interest and tax expenses are often added back when calculating metrics like Earnings Before Interest and Taxes (EBIT) or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Interest expense reflects the cost of borrowing and depends on a company’s financing structure, not its core operations. Tax expense is influenced by tax laws and a company’s specific tax situation. Adding these back allows analysts to compare operational performance without the influence of unique financing decisions or tax burdens, providing a pre-debt and pre-tax view of operational efficiency.

Discretionary Spending

Discretionary spending is another area for add backs. These expenses are not strictly necessary for core operations or could be significantly reduced by a new owner. Examples include excessive travel and entertainment, charitable contributions, or above-market rent paid to an owner-related entity. Adjusting for these items reveals the true operational profitability and highlights potential cost savings for a prospective buyer.

How Add Backs are Used

Business Valuation

Add backs play a role in business valuation, particularly for privately held companies. Potential buyers or investors evaluate a business’s true earning potential, separate from the current owner’s financial decisions or one-time events. By adjusting financial statements with add backs, analysts arrive at a normalized earnings figure representing sustainable profitability. This adjusted figure is then used to apply valuation multiples, helping determine a fair purchase price reflecting the company’s intrinsic value.

Lending Decisions

For lending decisions, banks use adjusted financials to assess a company’s ability to service debt. Lenders want to understand the business’s cash flow generation capacity independent of non-cash expenses or owner-specific compensation. By adding back items like depreciation and owner’s discretionary expenses, lenders gain a clearer picture of available cash flow to cover loan payments. This clarity helps them evaluate loan risk and determine appropriate terms.

Mergers and Acquisitions (M&A)

Add backs are also used in mergers and acquisitions (M&A) for more equitable comparisons between businesses. When acquiring a company, the acquiring entity needs to understand the target’s operational performance, free from historical accounting choices or non-recurring events. By normalizing the financials of both the acquiring and target company, add backs enable a “level playing field” for financial analysis. This adjusted view supports informed strategic decisions and helps negotiate fair deal terms based on comparable operational profitability.