Definition
Depreciation and amortisation are accounting charges that spread the cost of an asset over its useful life. Depreciation applies to physical assets such as vehicles, machinery and shop fit-outs. Amortisation applies to intangible assets such as capitalised software, purchased customer lists and, under some accounting rules, goodwill. Neither involves cash leaving the business in the year it is charged: the cash went out when the asset was bought.
Goodwill is the part of a purchase price above the value of a business's identifiable assets, less its liabilities. It reflects things like reputation, customer relationships and trained staff.
Worked example
Cobblestone Print Works is a fictional Canadian business. It buys a printing press for C$500,000 that should last ten years, and charges C$50,000 of depreciation each year.
- Profit before tax, after that charge, is C$200,000.
- With no interest to add back, EBITDA is C$200,000 + C$50,000, which is C$250,000.
In ten years' time, though, the business will need another press.
Net profit before tax is what a business earns after all its costs, including interest and depreciation, but before tax on its profits. It is the starting point for SDE and EBITDA.
EBITDA is earnings before interest, tax, depreciation and amortisation. It helps compare operating profit across businesses, but it is not the same as cash.
Why buyers care
SDE and EBITDA both add depreciation and amortisation back, which makes businesses with different asset histories easier to compare. Loupe's valuation tool does the same when it builds up earnings.
The risk is that adding them back can flatter a business that relies on equipment. Machinery still wears out and vans still need replacing. Compare the depreciation charge with what the business has actually spent on assets over several years. If spending has been well below depreciation, the seller may have held back replacements, and the bill could land soon after you buy.
Seller's discretionary earnings (SDE)
Seller's discretionary earnings is the yearly financial benefit a business gives one full-time working owner, before financing costs, non-cash charges and one-off spending.