Thin capitalisation: practical guidance: measuring earnings: earnings before interest, tax, depreciation and amortisation (EBITDA)
The use of EBITDA
Tax advisors will contend that since both depreciation and amortisation are non-cash transactions representing the wearing out of tangible and intangible assets respectively, these should be excluded from the calculation of interest (INTM516010) and debt cover (INTM517010).
EBITDA is a measure widely used in third-party agreements, but some thought should be given to the implications of departing from the operating profit, particularly in relation to adding back the depreciation charge. With no deduction for depreciation, there is no provision in the accounts for the use of tangible assets and for their eventual replacement.
If depreciation and amortisation are added back to the profit calculation, then clearly the quantum of earnings and the resultant interest cover will increase. In order to decide whether this is appropriate, one needs to consider whether the basis on which interest cover is calculated will serve its purpose as a measure of whether the borrower has sufficient earnings to support the obligations of the debt. It is no use if the computation offers false reassurance, in that an increase in capital expenditure or the loss of an income source can change the picture for the worse unexpectedly. For example, the link between depreciation and capital expenditure needs careful consideration, and if depreciation is to be taken out, then it may be appropriate to recognise budgeted or actual capital expenditure as a factor which a lender would take into account.