Thin capitalisation: practical guidance: measuring earnings: the effect of depreciation
Depreciation and capital expenditure
Depreciation is a non-cash item in the profit and loss account; nevertheless, it represents the gradual wearing out of a company’s assets, and these assets are likely to be replaced or upgraded some time in the future, with a resulting cash cost to the business.
A third-party lender would want to take account of this future outlay in considering the business’s ability to service its debt, particularly if the capital expenditure was likely to be substantial (relative to the company’s profitability),. If depreciation is added back, then the operating profit figure should be adjusted to take account of estimated or actual capital expenditure each year, to produce a more appropriate figure of available earnings.
Loan agreements sometimes set a limit on capital expenditure each year, and HMRC may do the same if circumstances suggest this is appropriate. If the expenditure limit is breached, the amount representing the excess is treated as having been funded by non-arm’s length interest-bearing debt, which falls to be disallowed.
An acceptable compromise in appropriate cases may be to use an earnings measure which does not add back the depreciation charge (‘EBITA’). This may be reasonable where depreciation and actual capital expenditure are likely to be similar, and therefore depreciation is an appropriate substitute for anticipated capital expenditure.
However, there are several reasons why it may be misleading to assume that depreciation and capital expenditure are comparable:
- new assets are likely to be more expensive “in today’s money” than the assets they replace
- modern equivalents of obsolete or worn out assets may be more complicated, and therefore more expensive. However, this is not universally the case, and some technology gets cheaper as it becomes more commonplace.
- businesses may branch out into new activities, needing assets not previously required
- depreciation is spread over a number of accounting periods; capital expenditure may heavy over a short period.
The depreciation issue is likely to be most significant in capital intensive businesses, so it is questionable whether using EBITA alone is sufficient to allow for future capital expenditure; the best response for capital-intensive businesses may be for EBITDA to be adjusted for actual (or projected) capital expenditure each year. What classifies as significant requires the exercise of judgement.