EBITDA vs EBIT when valuing an industrial business

Why does the earnings measure matter more in an industrial business?

EBITDA is earnings before interest, tax, depreciation and amortisation. EBIT is the same figure after depreciation and amortisation. In a consulting firm the two are almost identical, because there is little equipment to wear out. In a fabrication shop running a fibre laser, two press brakes, an overhead crane and a forklift fleet, the gap between them can be a large share of the profit. That gap is the cost of the equipment that produces the earnings.

EBITDA is popular because it compares easily across businesses funded in different ways. The trouble is that it treats the replacement of machines, vehicles and tooling as if it were free. A buyer does not. A buyer is paying for the cash the business can release each year after keeping its capacity where it is today, and in a capital-intensive business that cash can be far below EBITDA.

This article deals with that gap and nothing else. How maintainable earnings are capitalised, and when other methods take over, is set out in how we value industrial businesses.

Can two businesses with the same EBITDA be worth different amounts?

Yes, and the difference is often larger than owners expect. Take two manufacturers that report the same EBITDA.

That is why a buyer of Business B will either apply a lower multiple to its EBITDA or value it on earnings after a capital allowance. Done properly, both routes arrive at a similar answer. Ignoring the capital expenditure does not.

The size of the gap depends on things a profit and loss statement does not show: the age profile of the equipment, how quickly the technology moves (laser sources, CNC controls, vision systems on packaging lines), whether guarding, dust extraction or other safety upgrades are due, and how close the plant is to full capacity.

Why is depreciation in the accounts a poor guide to future capex?

Depreciation spreads what an asset cost when it was bought over its estimated life. It says nothing about what the replacement will cost. A press brake bought fifteen years ago and depreciated on its original price understates the cheque the business will write when it fails. In industrial accounts the depreciation line is usually distorted in one of three ways.

Tax rules set the number

Many owner-managed companies are small proprietary companies, which do not have to prepare annual financial reports unless shareholders or ASIC direct them to or another exception applies (Corporations Act 2001 (Cth) s 292(2)). Their accounts are usually prepared for tax, so depreciation follows tax rules. Under temporary full expensing, eligible assets first held from 7:30pm AEDT on 6 October 2020 and first used or installed ready for use by 30 June 2023 could be deducted in full. Where the accounts mirrored the return, the year of a big equipment purchase shows EBIT collapsing and the following years show almost no depreciation on that plant. Neither is a fair picture of what the plant costs the business.

Old plant is fully written off

A machine shop or fleet that has not been reinvested in can show very little depreciation because the assets are fully written off. EBIT looks healthy, but the replacement bill is close. This is the business that most needs a capital allowance and least shows it.

Overhauls are buried in repairs

AASB 116 Property, Plant and Equipment requires each significant part of an asset to be depreciated separately. In practice many smaller businesses expense major overhauls through repairs and maintenance: an engine rebuild on a loader, relining a furnace, a spindle rebuild on a machining centre. A heavy year makes EBITDA look weak and a quiet year makes it look strong. We spread those costs over the cycle rather than taking either year at face value.

How the equipment itself is treated in the value, including surplus assets and finance owing, is covered in how plant and equipment affects business value.

How do valuers estimate maintainable capital expenditure?

Maintainable capital expenditure is the average annual spend needed to keep the business producing its maintainable earnings at its current capacity. It excludes spending to grow. We build it from several directions and compare the answers.

1. The asset register. What is there, when it was bought, what it cost, its condition and its expected remaining life. Maintenance records and the people who run the machines often say more than the register does.
2. What was actually spent. Asset additions over five or more years, split between replacement and expansion. A second shift's worth of new equipment is growth; a replacement forklift is not.
3. What is coming. Known replacements over the next three to five years, such as a laser source near the end of its life, a compressor, trucks coming off finance, or overdue guarding upgrades.
4. Today's prices. Replacements priced from current quotes, not from what the old asset cost, less what the old asset should fetch on trade-in or sale.
5. Smoothing. Lumpy items converted to an annual allowance over their life, so one big year does not distort the result.
6. Capacity. If the plant is running near its limit, forecast growth needs growth capex as well. A forecast that shows growth without it is not credible.

Once the allowance is set, it has to appear in the valuation somewhere. It can be deducted from EBITDA, or it can replace the depreciation line to give an adjusted EBIT. Which presentation we use depends on the business and on the market evidence available. What matters is that the capital expenditure is not left out.

How does AASB 16 change EBITDA?

AASB 16 Leases applies to annual reporting periods beginning on or after 1 January 2019. A lessee recognises a right-of-use asset and a lease liability for leases longer than 12 months, unless the asset is of low value. The rent leaves operating costs and is replaced by depreciation of the right-of-use asset and interest on the lease liability. EBITDA rises by the whole of the rent, EBIT rises by less, and in the early years of a lease the total expense is higher than the rent.

For a valuation the rule is consistency. If a valuer works from EBITDA after AASB 16, the lease liability is treated like debt and deducted on the way from enterprise value to the value of the shares, and any market evidence used must be on the same basis. The alternative, common in private company work, is to keep the rent as an operating cost and leave the lease liability out. Either approach can be right. Mixing them, by using the higher EBITDA and then ignoring the lease liability, hands the buyer the factory rent-free and overstates value.

The basis also matters when businesses are compared. Larger companies that report under Australian Accounting Standards apply AASB 16. Many small proprietary companies keep accounts that simply expense the rent. An EBITDA figure from one cannot sit beside the other without adjustment.

Industrial premises bring a second issue. The factory is often owned by the founder's family trust or self-managed super fund and leased to the operating company. The rent may be above or below market. We normalise it to a market rent so that the earnings reflect what a buyer would actually pay to occupy the site.

When is EBIT the better anchor, and when is EBITDA?

• Capital-intensive operations such as machining, fabrication, food processing, packaging, contract mining and fleet-based transport: earnings after a maintainable capex allowance are usually the better anchor, whatever the headline measure is called.
• Asset-light businesses such as distribution from leased warehouses, freight brokerage, or industrial services where the main asset is skilled people: EBITDA and EBIT sit close together, and EBITDA is a fair shorthand once leases are treated consistently.
• Businesses mid-cycle that have just re-equipped, or are overdue to: neither the latest EBITDA nor the latest EBIT is maintainable on its own, so we look across a full replacement cycle.

Market evidence is usually quoted as a multiple of EBITDA, and every such multiple carries an assumption about capital expenditure inside it. When buyers pay less per dollar of EBITDA for a plant-heavy business, that is often the capex showing through. Our article on manufacturing business valuation multiples explains what else moves them.

What else needs adjusting before either figure is used?

Capital expenditure is the biggest industrial adjustment but not the only one. Before EBITDA or EBIT is capitalised we check these lines.

• Owner remuneration. The owner is often the chief estimator, production manager and key account manager at once. We replace what they draw with the market cost of the roles they fill, which can be more than they pay themselves.
• Profit on sale of assets. Selling a surplus press or an old truck above its written-down value creates a gain in other income that inflates EBITDA for one year.
• Related-party charges. Rent, management fees or equipment hire charged by entities the owner controls.
• Capitalised labour. Some manufacturers capitalise the wages of staff who build their own jigs, fixtures or tooling. That lifts EBITDA now and moves the cost into depreciation later.
• One-off costs. A stock write-down, a product recall or a legal dispute that will not recur.

What should owners and advisers do with this?

If you are preparing for a sale, a shareholder exit or a restructure, three things shorten the earnings discussion and make the outcome easier to defend. First, an asset register with realistic ages and replacement estimates for the major plant. Second, asset additions split between replacing equipment and expanding capacity. Third, a schedule of every lease, including any lease from a related party, with its rent and term.

With those in hand, the conversation moves from which number to use to what the business really needs to spend, which is the conversation a buyer will have anyway. The valuation readiness check lists what else to gather, and you can request a fixed-fee quote when you are ready.