Why it matters
Vehicles, machines, kitchens, roofs, shop fits and IT equipment all wear out. Keeping them working takes regular repairs and, every few years, replacement. An owner planning to sell has a reason to hold back on both, because money not spent shows up as profit in the final years.
SDE and EBITDA both add back depreciation, so neither shows how much cash the business needs to keep its assets in working order. If that spending has been held back, you buy the flattered earnings and inherit the catch-up bill as well.
It also affects how you finance the deal. Loan repayments come from the cash left after replacement spending. A fleet or production line that needs replacing in your first two years can absorb the cash you planned to use for debt service. Loupe's valuation tool works from SDE or adjusted EBITDA and does not ask about capital spend, so deduct normal replacement costs yourself when you judge whether the earnings will cover the loan.
Here is a fictional example. Pellingham Couriers reports EBITDA of $600,000. It runs 20 vans and, in a normal year, would replace four of them at around $50,000 each. The owner has not bought a van for three years. A normal year needs $200,000 of capital spend, so the cash the business generates is nearer $400,000, and on top of that sits a backlog of up to 12 vans that were not replaced.
For older or larger assets, an independent equipment inspection or building survey before you agree the price is money well spent.
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.
EBITDA is earnings before interest, tax, depreciation and amortisation. It helps compare operating profit across businesses, but it is not the same as cash.
Depreciation and amortisation spread the cost of long-lived assets over the years they are used. They reduce profit without any cash leaving the business in that year.
How to spot it
- Capital spending in recent years is well below the depreciation charge.
- Repairs and maintenance costs are falling while the assets get older.
- The average age of vehicles or equipment has been rising, and finance agreements that ended were not replaced.
- A site visit shows worn equipment, patched repairs or a tired fit-out.
- Safety inspections, servicing or certifications are overdue.
- Staff describe workarounds, frequent breakdowns or equipment they avoid using.
Questions to ask the seller
- What has the business spent on equipment, vehicles and premises in each of the last five years?
- Which major assets are due for replacement in the next three years, and what will that cost?
- Has any maintenance or replacement been postponed, and why?
- Are all safety inspections, services and certifications up to date?
- What repair or reinstatement obligations does the lease place on the tenant?
- Have staff or contractors recommended any work that has not been done?
Documents to request
- The fixed asset register, with purchase dates and costs
- Capital spending and repairs ledgers for the last five years
- Service and maintenance logs for major equipment and vehicles
- Inspection and certification records
- Quotes for any replacement or repair already identified
- The repairing clauses in the lease and any schedule of dilapidations (make-good obligations in Australia)