Discussion on the Treatment of Foreign Exchange Translation Gains and Losses in EBITDA Adjustments
In calculating standardized EBITDA for bank covenants or valuations, the treatment of foreign exchange gains and losses often sparks controversy. This article uses the example of a U.S. company selling in Mexico and Canada with receivables denominated in local currencies to analyze whether monthly translation gains and losses should be added back to EBITDA, and discusses the opposing views of non-cash expenses versus operating costs.
A common question when calculating normalized EBITDA used for bank covenants or valuations is: should foreign exchange gains and losses be excluded? The following scenario sparks discussion: a US company sells in Mexico and Canada, with sales and receivables denominated in local currencies. Receivables are subsequently settled in local currencies. However, when preparing monthly financial statements, non-US dollar items are translated, resulting in gains and losses.
The starting point of the discussion is: foreign exchange gains and losses are non-cash charges and therefore should be added back to EBITDA. The opposing view argues that foreign exchange risk is real and is part of operating costs.
Proponents of the add-back emphasize that translation gains and losses do not involve actual cash outflows, only changes in book value due to exchange rate fluctuations, so they should be excluded when measuring operating profitability to reflect core business performance.
Opponents of the add-back point out that foreign exchange risk arises from cross-border operations and is an unavoidable cost in daily business. If not added back, EBITDA better reflects the actual risks borne by the company and the funds needed for continued operations.
In practice, the treatment depends on the covenant terms and the purpose of the valuation. If the covenant explicitly lists foreign exchange gains and losses as non-cash items, an add-back is usually allowed; if not specified, judgment should be based on the principle of substance over form.
Additionally, a distinction should be made between realized and unrealized foreign exchange gains and losses. Realized gains and losses typically involve actual cash settlement, while translation gains and losses are mostly unrealized. In normalized EBITDA, unrealized translation gains and losses are more likely to be considered non-cash items.
Ultimately, companies should clearly disclose their adjustment policies in financial reports and communicate in advance with banks or valuation parties to avoid subsequent disputes.