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.
