EBITDA

EBITDA what it is, where to find it in your accounts and why it matters..

Earnings Before Interest Tax Depreciation & Amortisation

There’s a video below below showing you how & where to find it in a set of accounts… but first I’d like to explain why EBITDA is so important…

The finance community use it to compare your performance over time and with others…

… that’s it…

And to do that they need as clean a sense of your profits (earnings) as they can get…

So… they want a profit figure Before :

Interest

Because Interest is a function of capital structure… (some companies have debt, some don’t)… to compare performance between companies we want a profit figure that ignores a company’s capital structure…

Tax

Tax regimes around the world (and even across industrial sectors) can be / are different… so to compare performance between companies we want a profit figure that ignores Tax

OPERATING PROFIT

Ignoring Interest & Tax gives us your EBIT (Earnings Before Interest & Tax)… in a UK set of accounts you’ll find EBIT as Operating Profit in the Profit and Loss

Depreciation

Finding EBIT is easy… but now we have to dig around the accounts to find the ‘Depreciation charge for the year’ and add that back to the Operating Profit…

Why ? Because Depreciation is a book-keeping entry based on a policy decided by the company’s directors… one company might depreciate its assets (say vans) at 25% pa… another at 33%… which can affect profit dramatically

To compare performance between companies we want to ignore such a moveable / arbitrary / manipulable number

Amortisation

Fancy, old fashioned word for Depreciation of an Intangible Asset (such as Goodwill)… and as with Depreciation it needs to be added back if we want to compare company performance

EBITDA… There you have it

A universally used metric to measure performance… that you can’t find…

… you have to work it out… by :

  1. finding Operating Profit (from your P&L)
  2. adding back Depreciation & Amortisation (which you’ll find in the notes to your accounts… it’s the ‘charge for the year’ in the Fixed Asset (Non-Current Asset) table

 

 

 

 

audit

Audit… hear, hear

I never liked auditing… but I like audits

Way I see it there are only two reasons not to have an one… cost & hassle… but here’s a few thoughts on why having an audit can be a good thing

Credit Ratings…

… the agencies love audits… it means a pro has checked your systems to make sure the numbers produced are solid & that they class you as a Going Concern (likely to continue in business for the next year)… and that gets you a better credit rating…

Funders…

… bankers, shareholders et al get comfort from an audit… wouldn’t you, if you were them?

Buyers…

… you’d be happier buying a company whose numbers have been audited, right?

Hassle is good…

… the systems checks auditors do can help improve business processes, introduce best practice, and prevent fraud & cock-ups

 

The Government keeps lifting the limits and reducing the number of companies who MUST have an audit… but for companies looking to really scale-up that may not be doing them any favours…

I’m with the Norwegians… this ‘let’s exempt smaller companies’ has gone too far… they’re looking to introduce a Nordic audit for smaller businesses… but I won’t be holding my breath here in the UK…

Yet I’m not the only one to say hear hear to an Audit

Just over a quarter of respondents to an ICAEW survey of small businesses carried out in 2014 felt it would be better for the economy if businesses like theirs were required to have an audit. Nearly half of businesses with between 10 and 50 employees said they would have an audit even if this were not compulsory.

For financial years beginning 1st January 2016, a company is exempt from needing an audit if they meet 2 of the following :

Turnover over £10.2m

Total assets greater than £5.1m

More than 50 employees

That’ll stop another 10,000 companies needing an audit 🙁

Asset Lives

Asset Lives… they matter

How long you plan to use an asset affects the Depreciation going through your accounts… which means asset lives matter to your Profits and your Balance Sheet.

Assets are depreciated over the period you expect to use them…

If you expect to use a £100,000 asset for 4 years… this year’s Depreciation could be £25,000

If you decide instead you’ll use it for 5 years… this year’s Depreciation could be £20,000

That’s £5,000 extra profits Tax Free… (because Depreciation of Tangible Assets has nothing to do with tax)… and at the end of the year the asset will be carried in your Balance Sheet as worth £80,000 instead of £75,000

Profits up… Balance Sheet strengthened… a win win

All about Judgement

How long you’ll be using the asset is down to you… it’s all a matter of judgement (or educated guesswork)… and you can review asset lives every year...

So when you buy, say, a £100,000 asset you may expect to use it for 4 years… the Depreciation cost each year for the next 4 years will be £25,000

After 2 years it is in your Balance Sheet as an asset of £50,000

BUT… you realise you can now get another 5 years out of it … (perhaps because of repairs you’ve done, or you were being too cautious when you made your original estimate)

… so the Depreciation in year 3 will drop from £25,000 to £10,000 … !

Asset Lives… Definitions

The Useful Life of an Asset is defined by FRS102 as either…

1  The Period over which an asset is expected to be available for use by an entity… or

2  The number of production or similar units expected to be obtained from the asset by an entity

If you bought a £200,000 lorry you may have a policy of selling all lorries after 4 years… in which case you are using definition 1. and will depreciate the lorry over 4 years… so in the first year Depreciation would be £50,000

If instead you have a policy of selling lorries after 100,000 miles, you’re using definition 2…. and if in the first year you clocked up 50,000 miles… then the first year’s depreciation charge would be £100,0000

FWIW

Repairs & Maintenance do not stop the need to Depreciate assets… but they may change the expected Useful Life of the asset and so will either impact the Residual Value.. or prolong the period that the company will use the asset (and so reduce the Depreciation charge each year)

Useful Life… An asset’s life in this context is not the total expected life of the asset… but the period that the company will get use from it… (“the period from which the entity expects to consume economic benefits from the asset”).

FRS 102 para 17.21 gives 4 points to consider when determining the Useful Life of an asset

 

 

 

 

 

Residual Value… there’s real value in there

Accounting rules mean your profits get hit by Depreciation… but you don’t have to take that lying down.

Ask your accountant how they handle the Residual Value of your assets… it could boost your Profits… tax free.

Residual Value… definitions

Your company’s depreciation policy is “the systematic allocation of the depreciable amount of an asset over its useful life”*…

… a few strange technical phrases in there.. but it’s the ‘depreciable amount’ that I’m interested in here… because that’s defined as “the cost of an asset… less its residual value“*

and ‘residual value’ is in turn defined as “the estimated amount that an entity would currently obtain from disposal of an asset… if the asset were already of the age and in the condition expected at the end of its useful life”*

What’s it mean?

You take the cost of your asset… and then deduct the expected value of that asset when you stop using it… before working out the annual Depreciation cost of using that asset

… say this year you bought a company Car that cost you £100,000… and you expect to use it for 4 years…

… some accountants would charge £25,000 Depreciation against this year’s profits for using the car… (£100,000 spread over 4 years)

BUT

… at the end of the 4 years the car still has Residual (second hand) Value… estimated today to be, say, £40,000

So the REAL cost of using the car this year should be…

Original Cost £100,000 – £40,00 Residual Cost … =  £60,000  spread over the 4 years you’ll be using it…

That would make this year’s Depreciation charge £15,000… instead of £25,000

So accounting for the Residual Value of your company car when you stop using it has generated an extra £10,000 Profit… tax free… and a stronger Balance Sheet too.

Who decides the Residual Values… & how?

You’re responsible for your accounts so it’s really up to you.. but best to get your accountant on board…

…  under the new FRS102 rules Residual Value is calculated by looking at the price your asset will fetch at your year end date… but making allowance for the age & condition it will be in when you stop using it…

(so… your £100,000 car may have been new this year … but at your year end you can figure out its Residual Value by looking at prices for a 4 year old version of the same car)

Objections?

How can there be?… rules is rules and the new FRS102 says Residual Values should be considered regularly to make sure they stay up to date… so you can revisit any old Residual Values your accountant’s been using…

… and if your accountant hasn’t been using Residual Values before… get them to start doing it… changing the way they depreciate your assets would be considered a change in an ‘estimate’ so needs no extra disclosure or any restating of old numbers…

FWIW

The old rules said Residual Values should be based on prices prevailing at the date of acquisition (or revaluation)….

The new rules say Residual Values should be based on prices prevailing at the Balance Sheet date*

*FRS102 Glossary of Terms

also FWIW…

A change in depreciation method is accounted for as a change in an estimate … IFRS 102 para 17.23