Case 057Earnings quality and adjustmentsCore

Lekhani Software capitalises 40% of its R&D while its peers expense all of theirs. Restate EBITDA and EBIT on a comparable basis.

The situation

Lekhani Software sells accounting software to mid-sized companies. Revenue is Rs 2,000 crore and reported EBITDA is Rs 600 crore, a 30% margin. It spends Rs 500 crore a year on research and development, of which 40%, Rs 200 crore, is capitalised as an intangible asset; the remaining Rs 300 crore is expensed.

Amortisation of R&D capitalised in earlier years is Rs 120 crore this year, and other depreciation is Rs 60 crore. Every listed peer expenses all of its R&D. Peers trade around 15x EBITDA.

Your task

Restate Lekhani's EBITDA and EBIT so they compare with peers, and explain what the difference does to a multiples valuation.

Quick check

On a comparable basis, what is Lekhani's EBITDA margin?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Comparable EBITDA is Rs 400 crore, a 20% margin, not 30%; comparable EBIT is Rs 340 crore against Rs 420 crore reported. Expensing the Rs 200 crore of capitalised R&D removes it from EBITDA in full. At EBIT the gap is only Rs 80 crore, because Rs 120 crore of past R&D is already amortised there. Applying the peer 15x to reported EBITDA would overstate value by Rs 3,000 crore.

Step 1Where does capitalised R&D go in the accounts?

Onto the balance sheet, and back into profit slowly. Capitalising moves a cost out of operating expenses and into an asset, which is then amortisedCharged to the income statement in instalments over the asset life, as a non-cash expense below EBITDA. below EBITDA over several years. It is like two families who each spend Rs 5 lakh on a kitchen: one calls it this year's household expense, the other calls it an asset and charges Rs 1 lakh a year for five years. Same money, same kitchen, very different first-year budget.

Step 2What are comparable EBITDA and EBIT?

Put Lekhani on the peers' policy: expense all Rs 500 crore and stop amortising. EBITDA falls by the full Rs 200 crore capitalised, from Rs 600 crore to Rs 400 crore, a 20% margin. EBIT falls by less: you lose Rs 200 crore of expense relief but also remove Rs 120 crore of amortisation, so EBIT drops by a net Rs 80 crore, from Rs 420 crore (21%) to Rs 340 crore (17%).

Capitalising R&D moves cost below EBITDA, not out of the businessAs reported: 200 capitalisedRevenue2,000R&D expensed(300)Other operating cost(1,100)EBITDA600 (30%)R&D amortisation(120)Other D&A(60)EBIT420 (21%)200 of R&D sits in investing cash flowComparable: all R&D expensedRevenue2,000R&D expensed(500)Other operating cost(1,100)EBITDA400 (20%)R&D amortisationnoneOther D&A(60)EBIT340 (17%)same cash, same as peers
Lekhani reports EBITDA of Rs 600 crore, a 30% margin, and EBIT of Rs 420 crore; with all R&D expensed like its peers, EBITDA is Rs 400 crore, 20%, and EBIT is Rs 340 crore, because capitalisation shifts Rs 200 crore of cost below EBITDA and Rs 120 crore of past cost returns as amortisation.
The relationship
EBITDAcomp=600−200=400EBITcomp=420−200+120=340\text{EBITDA}_{comp} = 600 - 200 = 400 \qquad \text{EBIT}_{comp} = 420 - 200 + 120 = 340
600reported EBITDA
200R&D capitalised this year, now expensed
120amortisation of past capitalised R&D, removed because nothing is capitalised
What it says in wordsComparable EBITDA loses the whole capitalised amount; comparable EBIT loses it but gets the amortisation back.
Step 3Why does it matter for valuation?

Because the multiple you borrow from peers was computed on their policy. 15x reported EBITDA gives Rs 9,000 crore; 15x comparable EBITDA gives Rs 6,000 crore. The Rs 3,000 crore gap is 15 times the R&D that was moved below the line. EBIT multiples are less distorted, because amortisation partly offsets, and free cash flow is not distorted at all: capitalised R&D sits in investing cash flow, so cash out the door is Rs 500 crore under either policy. Whenever two companies treat a large cost differently, valuing on free cash flow sidesteps the argument.

Apply the peer multiple to the wrong EBITDA and value is overstated by half15x reported EBITDA of 600Rs 9,000 crore15x comparable EBITDA of 400Rs 6,000 croreGap Rs 3,000 crore: 15 times the Rs 200 crore of R&D that was moved below EBITDA
At a peer multiple of 15x, Lekhani's reported EBITDA of Rs 600 crore implies Rs 9,000 crore of enterprise value against Rs 6,000 crore on comparable EBITDA, a Rs 3,000 crore overstatement from accounting policy alone.
Step 4Is capitalising R&D wrong?

No, and saying so earns credit. Accounting standards allow development costs to be capitalised once a project meets tests of technical feasibility and an intention to complete it; check the current standard and the company's note for the exact criteria. The question is not whether the policy is allowed but whether the numbers are comparable. Two signals deserve a follow-up question. Capitalisation of Rs 200 crore against amortisation of Rs 120 crore means the asset is growing, so reported profit runs ahead of cash cost every year R&D grows. And a rising capitalised share, say from 30% to 40%, flatters margins without any change in the business.

Where candidates lose it

The usual error is adjusting EBIT by the full Rs 200 crore and forgetting that the amortisation of past R&D disappears too. That double-counts and makes EBIT look Rs 120 crore worse than it is.

The second is the reverse at EBITDA: assuming the amortisation offset applies there as well. Amortisation is below EBITDA, so the whole Rs 200 crore comes out.

What the interviewer asks next

  • R&D grows 20% a year and is amortised over five years. Does the gap between reported and comparable EBIT shrink or grow?
  • How would you restate the balance sheet and ROCE on the expensed basis?
  • Which line in the cash flow statement shows the capitalised R&D?

Company names and figures are illustrative.