Depreciation Affects Business Valuations

Depreciation is an accounting method used by businesses to spread out the cost of up front capital expenditures (capex) over time in their income statements. Businesses may use depreciation as a taxable deduction when purchasing tangible or physical assets that have a useful life of more than one year. The taxable deductions are taken or expensed in the income statement according to a depreciation schedule set by the Internal Revenue Service. Because depreciation is a non-cash accounting charge and would not be a cash expense incurred by the buyer, it is generally considered to be an add-back and part of the adjusted owner benefit of a business. Business valuations are a multiple of a company’s adjusted owner benefit, so depreciation must be well understood and well explained to potential buyers by the business broker.

Depreciation Charges Absent from EBITDA

A common technique to measure the underlying profitability of a businesses is deriving its EBITDA or Earnings Before Interest, Taxes, Depreciation, and Amortization. This measure of profitability adds back the taxes, financing costs (assuming company debt is not transferable), and non-cash expenses in order to get a clearer picture of a company’s pre-tax cash flow. When valuing a business, other items which obscure a company’s true profitability such as the owner’s salary and personal expenses of the owner that flow through the income statement are also added back in order to derive the adjusted owner benefit. The key point in deciphering whether depreciation is truly an add-back for purposes of business valuation is the extent to which the business requires ongoing capital expenditures to sustain its current level of profitability.

Maintenance Capex v Growth Capex

The difference between maintenance capex and growth capex is of paramount importance when determining whether depreciation should be considered an addback to the adjusted owner benefit.
Maintenance capex is generally recurring and used for the purpose of maintaining a company’s current level of operations and profitability.
In contrast, growth capex is for the purpose of increasing a company’s operational efficiency, sales, or profitability.
Growth capex is far more common than maintenance capex unless a business is very well established and is already well along its growth curve.
Depreciation that stems from maintenance capex may not be considered an addback since the buyer would need to also employ similar capital expenditures in order to sustain the current level of sales and profitability.
For example, an HVAC business with a fleet of ten vehicles may need to purchase one truck per year just to replace an aging truck in its fleet.
The net capital expenditure involved in purchasing the replacement truck may be characterized as maintenance capex.
Since a buyer would also need to incur the same annual maintenance capex, the depreciation charges should not be considered an addback.
In contrast, the depreciation taken by an HVAC business via growth capex from an additional truck purchase in order to hire another technician and serve more customers is added back to adjusted owner benefit.
Most depreciation charges is assumed to be growth capex unless the business is in certain industries such as manufacturing or construction where a high amount of regular capital expenditures is required to sustain the current level of profitability.
Ultimately, determining whether capex is for maintenance or growth is a judgment call that a buyer must make.

Ensure Capex is Depreciated

Business owners should ensure that any capital expenditures for fixed assets with an internal use of more than 12 months (such as vehicles, machinery, and equipment) are depreciated. Expensing the entirety of a capital expenditure up front in the current year it was purchased does reduce tax liability and may be permitted by aggressive accountants. Doing so, however, obscures the income statement by unfairly expensing the entire amount of capex in the current year even though the asset has a useful life beyond the current year. Importantly, this tactic reduces the reported adjusted owner benefit in the current year, which will negatively impact the business valuation. Business owners should not be penalized by deploying capex, particularly when it is used to grow the business for the benefit of themselves and the buyer after the sale.

Example of Depreciation Impacting Business Valuation

Joe’s HVAC company has a fleet of ten trucks used to service customers.
One day, Joe spends $100K on a brand new and fully equipped truck (with a useful life of about 10 years) in order to grow his fleet to eleven trucks.
Joe’s accountant expenses the entire cost of the truck in the year it was purchased (and thus does not depreciate the value of the truck over time).
Joe subsequently receives a business valuation in anticipation of selling his business.
The business broker evaluates the most recent financial statement and notices the large expense of $100K for the truck.
Unfortunately, Joe’s annual adjusted owner benefit is reduced by this $100K expense since it was all expensed as an operational expense.
Potential buyers are unlikely to believe that such an expense was related to growth capex since it was all expensed as an up front cost to the business.
Joe’s annual adjusted owner benefit would have been $500K, but is instead reduced to approximately $400K.
The valuation multiple for Joe’s business is 4 x adjusted owner benefit.
Joe’s business valuation is thus $1.6M ($400k x 4) instead of $2M ($500K x 4).
For purposes of selling his business, Joe is much better off ensuring that the $100K cost for the truck is depreciated over time (ten years) which results in a depreciated expense of approximately $10K/year.
Note also that in each scenario, the truck itself is included in the sale of the business.

Depreciation – or spreading out costs related to capex over a period of time – is properly characterized as an add-back to owner benefit unless clearly related to maintaining the current level of sales, profits, and efficiencies. Both buyers and sellers of businesses should be aware of the basic accounting principles behind depreciation in order to properly value businesses.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.