The Income statement :Understanding Depreciation

One of the things that analysts and investors frequently look for while analyzing a company is the amount of depreciation written as expense in the profit and loss account. It is a term frequently used in finance that describes the loss of value over time. Depreciation is an expense; hence less of this expense would mean higher profits! Similarly, a steep rise in the depreciation would result in the company’s earnings falling below the expected levels, however profitable their operations are.
Depreciation is calculated as Cost – (minus) estimated residual value / Life of the asset. A change in any one of these measures — cost, residual value or life — will result in a change in the amount charged as depreciation.

There are also two methods of calculating depreciation – straight line method and written down value method. – a change in the depreciation policy can also bring in huge difference in the profits either positively or negatively.

As an investor you need not dig deep into this topic. What you need to understand is the following points:

  • Depreciation is an expense
  • It is a non cash expense. That is, there is no outflow of cash from the company.
  • The choices that a company makes in deciding how to amortize and depreciate — and by what amounts — will affect its overall appearance of financial health. The amounts will play probably a large part in determining the figures on the company’s balance sheet. They will also affect the profit figures on the income statement. These two documents are enormously important in determining everything from shareholder/investor returns to credit worthiness.
  • An increase in depreciation also means that the company has acquired new assets. High growth oriented companies, which are on an expansion spree may acquire lot of assets in the form of machinery and other fixed assets. So, to that extent it’s also a positive sign.
  • A fall in profits due to increased depreciation expense cannot be taken as a negative sign if the increase depreciation figure is due to acquisition of fixed assets
  • However, if the depreciation figures show material change due to factors like charging different depreciation rates or due to changes in the method of calculating depreciation etc… You may better be careful.
  • Since depreciation is an expense that depends on lot of factors, investors consider the Profit Before Deprecation and Taxes for valuation purposes.
  • Amortization and depletion are other expenses similar to depreciation that’s non cash in nature.
  • Amortization is a process that is exactly same as depreciation, for an intangible asset. We said in our earlier chapters that the business may have tangible assets like machinery or intangible assets like patents and goodwill. When tangible assets are written off at a specific rate, its called depreciation and when intangible assets are written off, it’s called amortization.
  • Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well’s setup costs are spread out over the predicted life of the oil well.
  • Being non cash expense, these three items decreases the earnings figures of the company but helps in increasing the cash flow of the company.
  • It can also have significant effects on tax burden. The less a company claims as depreciation/amortization, the more profitable the company seems and therefore the more it will be taxed. Choosing higher depreciation amounts can provide short-term tax relief.

Where to look

The best place to find information on all this is the schedules to the balance sheet and notes to accounts in the company’s annual report or quarterly results. The schedule on ‘Significant Accounting Policies’ will give the method and rates of depreciation, along with other accounting treatment specifically followed by the company. The notes to accounts explain the accounting treatment to give us an idea of how the depreciation of that particular year has been arrived at.

You may like these posts:

  1. The Income statement: Understanding the components.
  2. The Income statement: Profits
  3. The Income statement : Understanding the “matching principle”.

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