In capital-intensive industries, misclassifying capital expenditure (capex) can undervalue a business during a sale. Properly segregating capex into categories for replacement and growth assets can present a more accurate and often higher earnings profile by credibly boosting normalised EBIT.

Building on the Capital Replacement Provision
In another article, we explained why capital-intensive businesses should adopt a provision for capital replacement instead of traditional depreciation expense, as it provides a clearer measure of ongoing operational costs. This is particularly useful when EBIT (Earnings Before Interest and Taxes) adopted by investors as a profitability metric rather than EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation). By focusing on actual replacement requirements, we ensure EBIT reflects the real cost of maintaining the asset base, not the quirks of non-cash depreciation.

To ensure accuracy and prevent overstatement of replacement requirements, a key cross-check involves analysing historical capital expenditure. We go beyond surface-level reviews by providing our clients with a simple process to dissect each year’s capital expenditure. This segregation isolates true asset maintenance needs from investments designed to fuel growth ensuring normalised EBIT isn’t unfairly penalised for expansion activities that haven’t yet flowed through to earnings.

The Segregation Process
Our capex segregation process categorises expenditures into four key areas:
–  Private/unrelated assets: Non-business items, such as personal assets or unrelated assets, which are irrelevant to valuation and excluded entirely.
–  Leasehold assets: Fitouts or improvements to leased properties, these often require separate treatment because their useful life is linked to lease terms and may not fully transfer on a sale.
–  Growth assets: Investments in new assets or expansions, like entering new markets or increasing capacity which generate future revenue.
–  Replacement assets: This is the critical category. This is expenditure required to maintain existing operations and service levels, such as repairing, refurbishing or replacing worn-out equipment at similar capacity.

Only replacement capex is included when calculating the capital replacement provision for normalised EBIT. This ensures we’re not penalising the business for growth-oriented spending, leading to a fairer maintainable earnings profile.

Real-World Examples
We’ve applied this method successfully across various industries with significant uplift in valuation.

A commercial laundry client spent heavily each year on linen. By segregating this expenditure between replacement linen for their existing customers and growth linen to service new contracts, we reduced the replacement expense by approximately 40%. This significantly increased normalised EBIT and strengthened the overall valuation.

The owner of a Crane Hire business had upgraded old cranes with newer, higher-capacity models. To deal with this, we recategorised the investment into the base replacement cost for maintaining current capability and the premium cost attributable to the increased capacity as growth. This justified a lower ongoing replacement provision, boosting normalised EBIT by significant amounts while highlighting future growth potential in the Information Memorandum (a key document in M&A processes that outlines the business for potential buyers).

To illustrate the impact, consider this simplified comparison:

By segregating, sellers can add growth capex costs to the purchase price if those assets haven’t yet contributed to historical earnings as well as incorporating them into forward-looking forecasts.

While many businesses are valued based on EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortisation), some investors in capital-intensive industries such as construction, transport, equipment hire and vehicle rentals may focus on EBIT instead. These businesses carry substantial asset bases, and depreciation and amortisation (DA) often represents one of the largest expenses, so can’t easily be ignored.

Where EBIT is adopted, we need to normalise the true depreciation expense so that EBIT is not understated.

Depreciation is meant to reflect the consumption of an asset over its useful life. In practice, however, it is often distorted. Many businesses, particularly in the mid-market, don’t run separate depreciation schedules for accounting and tax. Instead, they adopt tax depreciation rates directly in their financial statements, which eliminates timing differences but introduces several challenges. Factors like instant asset write-offs, irregular asset sales and growth purchases distort the reported depreciation expense. As a result, depreciation isn’t always a “true” reflection of the real capital requirements of the business and if not adjusted, understates maintainable EBIT.

To overcome this issue a Provision for Capital Replacement is often applied. This is a notional expense that represents the real capital expenditure required to maintain the asset base operational in a going concern business.

A credible capital replacement provision is built by:

Assessing the true asset life using observed replacement cycles, utilisation patterns and historical longevity and not tax schedules.

Estimating realistic replacement costs by applying current market values adjusted for trade-in estimates or resale recoveries.

Excluding growth capex and including only the spend required to maintain the existing asset base.

This bridges EBITDA to EBIT without overstating expenses, thereby preserving business value.

Buyers will often cross-check these calculations against historical replacement capex (excluding growth assets).

Real-world examples of how we applied this in client sale negotiations:

In one case, a client’s MINESPEC vehicles were reliably held for more than 10 years with known trade-ins. The real economic depreciation was close to 5% annually, far below the tax rate. This rate was successfully applied in the EBIT calculation, resulting in a stronger valuation.

In another example, a client’s business model involved purchasing near-new ‘yellow goods’ (heavy machinery) at wholesale auctions at around 3,000 hours, using them to 10,000 hours, and selling in the local retail market. The true depreciation was again approximately 5% per annum. By applying this justified Provision for Capital Replacement we avoided value leakage that would have occurred by relying on inflated book depreciation expense.

By properly assessing capital replacement requirements rather than relying on headline depreciation figures, sellers present a more accurate picture of sustainable EBIT. This eliminates distortions, enhances valuation credibility and often results in a more favourable outcome for business owners.

Since the introduction of AASB 16 in 2019, valuing businesses using market multiples, especially EV/EBITDA, requires a new level of care. The accounting change does not alter business fundamentals, but it does reshape reported earnings and leverage in ways that can distort valuation if not handled consistently.

Under the old IAS 17, operating leases were off-balance sheet and recognised as an operating expense.
For reporting entities, AASB 16 brought operating leases onto the balance sheet as a right-of-use asset and a lease liability, replacing operating lease expenses with depreciation and interest.

The result is that EBITDA artificially rises post AASB 16, and lease expenses such as rent on properties disappear.

The core principle remains that AASB 16 doesn’t change value, it changes presentation.
The key to multiple-based valuation is consistency between the earnings metric and the multiple applied.
For example:
• If applying an EBITDA multiple to a business reporting under AASB 16, use comparable peers that also apply the standard.
• Another option is to normalise the AASB 16 depreciation & interest back to an operating expense to align with pre AASB 16 reporting and use multiples from peers not affected by the standard.

At DMA, we have seen a range of approaches across transactions. The key is ensuring consistency in metrics used and presenting the underlying performance of the business in a transparent and consistent manner where AASB 16 is involved.

It is important that the selected approach is carried through the entire transaction process, ensuring it is reflected consistently in completion accounting and/or earnout calculations that feature in the binding transaction documentation.

There is often considerable confusion surrounding the treatment of working capital when selling a business.

Working capital plays a crucial role in Enterprise Value calculations, sale price allocation, and sale adjustment calculations. Many business owners, and even some advisors, do not fully grasp how working capital impacts the goodwill of a business and its accounting in the context of a business sale. The consequences of this lack of understanding can be significant, with owners potentially forfeiting substantial value without realising it.

What is Working capital?
Working capital refers to the current assets and liabilities necessary for the day-to-day operations of a business. These assets and liabilities are constantly converting from one category to another, ultimately into cash, and they vary from business to business. On the asset side, working capital normally includes items such as inventory, WIP, trade debtors and other debtors, and prepayments. On the liability side, it normally encompasses trade creditors, customer deposits, and other current liabilities.

Counter-intuitively, it includes all of these EXCEPT cash! This is because a transaction based on Enterprise Value typically excludes cash (and debt), ie on a cash-free, debt-free basis. This is different to Equity Value, which does include those items.

When calculating Enterprise Value, it is essential to consider how working capital features in the process. No credible Enterprise Value can be calculated without including working capital and understanding the cash cycle. Net working capital represents the ongoing investment required to generate profit in a business.

Is it better to have more or less working capital?
The answer depends on the context, whether it pertains to the ongoing operation of the business or specifically to the context of a sale.

Well-run businesses strive to minimise net working capital to make their money work harder and generally achieve a higher return on funds employed. However, many business owners do not pay attention to how much of their investment is tied up in working capital, and it can often grow without anyone reacting to it. Most business owners or managers aim to maximise profit, and driving sales and margins is an effective way to achieve this. These drivers encourage maintaining adequate levels of stock, often buying in bulk at the best prices, offering extended payment terms, and/or paying suppliers early to foster stronger relationships. These factors tend to increase net working capital while driving profit up.

The Effect of Working Capital on Sale Returns
The dynamics of working capital change entirely when a business owner transitions from ‘running the business’ mode to ‘selling the business’ mode. Goodwill is the difference between the enterprise value (based on a multiple of earnings) and the value of net tangible assets, including plant & equipment and net working capital. Therefore, in basic terms, the lower the working capital requirement, the less money is tied up in the business. With the overall sale price unchanged, this means achieving the same sale price while having more money ‘off the table’ and already in the owner’s pocket. This translates to a higher potential goodwill component of the price.

With over 25 years experience guiding business owners through successful transactions, DMA understands the nuances of working capital and how it affects transaction outcomes. DMA combines rigorous analysis with practical sale structuring advice to help clients maximise transaction proceeds.