Earnings BEFORE Debt Service & Taxes Calculator
This calculator (further down) has been approved by an accounting professor who formerly worked as an accountant at Ernst & Young and PricewaterhouseCoopers.
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For more information on the formula behind this calculator, scroll down below the calculator. Before you use the calculator, let’s do a short refresher on capital expenditures (found on the cashflow statement).
What are Capital Expenditures (CAPEX)? “Capital expenditures (CapEx) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. CapEx is often used to undertake new projects or investments by a company. Making capital expenditures on fixed assets can include repairing a roof, purchasing a piece of equipment, or building a new factory. This type of financial outlay is also made by companies to maintain or increase the scope of their operations.” –Investopedia
What is maintenance CAPEX? CAPEX can be broken into two categories. The first is maintenance CAPEX which is the CAPEX necessary to maintain the company’s competitive advantage or existing form (in theory, CAPEX not leading to production expansion). The second is growth CAPEX which is the CAPEX on new assets that are used to grow the company beyond its competitive advantage or existing form (in theory, CAPEX leading to production expansion). More or less, you can think of it as maintenance CAPEX as accounting for the CAPEX necessary to maintain existing revenues, and growth CAPEX as accounting for the CAPEX necessary to grow revenues beyond inflation.
[When looking at financial data, you should always use averages. For example, a 3-year average. Averages should be used especially when talking about maintenance CAPEX, because every year is going to be different.]
So, Maintenance CAPEX = Total CAPEX – Growth CAPEX
For example, if your pest control company has 20 trucks, all CAPEX for maintaining those trucks or to buy new ones when those 20 are no longer useable would go into the maintenance CAPEX category. If in 2022 your pest control company buys 5 more trucks to grow your existing fleet to 25 trucks (which would lead to more production or output assuming you hire more workers or the existing workers are more efficient), that would be considered growth CAPEX. Or, if every year a large hospital grows its working number of X-ray machines by two to account for increasing demand because the hospital provides quality service, that would be considered growth CAPEX.
Earnings Before Debt Service and Taxes = Average Annual EBITDA – Average Annual Maintenance Capital Expenditures
This is what is left over each year to pay debt service (interest expense + principal payment) and taxes, assuming no change in non-cash net working capital (accounts receivable, accounts payable, inventory, etc.).
Important Information About This Calculator:
You should use annual numbers. 3 to 5 year averages for these calculations will give you the fairest estimate for the future based entirely on the past (if you manage the company in the exact same way as the owner and other external factors are the same like the economy).
This calculator is sometimes referred to as Warren Buffett’s formula for owner earnings, although he wasn’t the first person to use it. This really is the true, pretax earnings for a company with no debt-service payments (excluding the adjustments for amortization, which we don’t discuss here because it doesn’t often apply to small cap companies).
Remember, this calculator is calculating the earnings for the past 3 to 5 years. This is not a financial model or prediction which is purely speculation. I can’t emphasize that enough. Financial models that apply growth rates are predictions. The future is entirely unknown. Ever notice how every predictive financial model given to you by a broker or investment banker will apply a growth rate? Ever seen a financial model with negative growth rates? Probably not. Well, we know a lot of financial models should theoretically have negative growth rates, because not all acquisitions work out. So, be careful when you yourself create financial models, and throw any financial models from third parties with misaligned incentives in the trash.
After you pay debt service, you will have to pay tax as well. Why are we calculating taxes last? Because the interest expense is tax deductible (but the loan/principal repayment is not). To make it more simple, we just forget about tax until after debt service, but remember that this is only an approximate calculator/formula, and that principal payments aren’t tax deductible. So, this number won’t be exact if your debt service payment includes a lot of principal. Interestingly, most of the early payments are going to be mostly interest, slowly increasing with time towards having more principal. Some loans are specially oriented as “interest only” for a certain amount of time as well.
Also, understand the working capital nuances of your industry and/or the acquisition target. Some companies will require greater strength in terms of liquidity or working capital. Depending on how you structure the transaction and the acquisition target’s balance sheet, your working capital situation after the closing will require attention that this financial calculator is not taking into account.
If you want a rougher version of what you can use to calculate a debt service coverage ratio (DSCR), just use EBIT.
However, I would not use EBITDA because you will have maintenance capital expenditures. You have to pick what you are going to deduct from EBITDA. Are you going to deduct the average annual depreciation figure, or are you going to deduct the average annual capital expenditure figure?
Just because a lot of people like to say and use EBITDA, doesn’t mean it is correct. Capital expenditures don’t disappear when you buy the company.
Don’t believe me? That’s fine. See below.
“Does management think the tooth fairy pays for capital expenditures?” – Warren Buffett
“It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.” – Warren Buffett
“Last year, for example, BNSF’s interest coverage was 9:1. (Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly-used measure we view as seriously flawed.)” – Warren Buffett
“Depreciation charges are a more complicated subject but are almost always true costs. Certainly they are at Berkshire. I wish we could keep our businesses competitive while spending less than our depreciation charge, but in 51 years I’ve yet to figure out how to do so. Indeed, the depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly, a mismatch that leads to GAAP earnings that are higher than true economic earnings. (This overstatement of earnings exists at all railroads.) When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.” – Warren Buffett
“Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet.” – Warren Buffett
“Depreciation charges, we want to emphasize, are different: Every dime of depreciation expense we report is a real cost. That’s true, moreover, at most other companies. When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.” – Warren Buffett
Bottom line: use the formula/calculator discussed here or use the average 3 to 5 year EBIT when buying small businesses (it can get more complicated when buying public companies that have amortization, goodwill, and other accounting jargon). As always, talk and verify all outside information with your accountant, lawyers, and financial advisors.
Balancing month-to-month net working capital (short-term liquidity), capital expenditures, debt payments, and revenue & cashflow.
This is why you must know your sector and be conservative when estimating numbers.
- Net working capital = Current Assets (cash, accounts receivable, inventories) – Current Liabilities (accounts payable, short-term borrowings, accrued liabilities)
- This is something that will need monitoring. You may need to get a working capital line of credit from your bank. It all depends on your business. Some businesses need more cash. Some businesses have buildups in accounts receivables (which can turn into a cash problem, which then can turn into a debt service problem). Some companies need high amounts of inventory, where a lot of the cash just gets funneled into inventory to keep the company running. This is important because with a leveraged buyout you have debt service you need to pay every month, so you have to be aware. This is why a strong deal has a high DSCR (or high enough). Or, at least a stable DSCR. I’d rather have a stable DSCR than a high DSCR that is going to change a lot over time – at least when I have debt payments due (common sense). In other words, high volatility in DSCR (or cashflow) can be fine, but it is not ideal when you have debt service payments.
- Capital expenditures. These change on a month-to-month and year-to-year basis. What if 5 of your trucks break down? Or, you need more machinery because old machinery is out of date?
- Revenue and cashflow. This will change on a month-to-month basis.
- Debt repayments. Aren’t going to change on a month-to-month basis.
You can probably see where I am going with this… Everything changes except monthly debt service. Now, I am not saying that revenue can’t go up! Not at all. What I am saying is, it can go up and it can go down on a month-to-month basis. This is predicated on you, your team, your deal, your industry, your management, the economy at large, some luck, etc. Execution is required.