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Depreciation

How we assign a value to long term assets
MV
Written by Max Valentine
Updated 6 months ago

In this section we will cover Depreciation and Amortisation, you may have heard of this concept when buying a car.  If you buy a new car, it is said that you have lost value as soon as you leave the showroom.  Also keeping on the car theme, if you have used asset finance or hire purchase to own a car, a key element of your monthly charge is the depreciation so you will see the cost differ greatly based on the miles (usage) and contract term (age) all which impact the price that the car can be resold.

To calculate depreciation, we need to understand the concept of capital expenditure. This is the cost of any asset with an economic life of greater than one year when purchased and it is held for continuing use in the business.

The idea behind depreciation is that we cannot allocated the whole cost of a long-term asset e.g. machinery, building etc in the purchase year as this would normally lead to significant losses in that time period (and goes against the accruals concept which is the intention is to match the costs over the life of the profits they generate).

There are four common methods of depreciation which are all based around assigning a depreciable amount which is defined as the original price of the asset less its estimated resale price or residual salvage value.

Straight line - This method assigns an equal (linear) depreciation value based on the number of useful years.

 Declining balance - this approach calculates the proportion of the remaining value to depreciate each year based on the initial purchase price not that appreciable amount this rate is usually a function of the economic life and a multiplier

 Sum of digits – this method takes the economic life but apportions on increasing or decreasing proportion per year and then there's the usage basis this amortises the depreciable amount based on what proportion of the asset is estimated to have been used in a particular year this is quite common in mining and resource industries

But you don’t have to worry about that, at numberslides we use the straight-line methodology which is by far the most common method and favoured by accountants. 

Let’s take an example:
If your business bought some machinery worth £400,000 and has an expected useful life of 10 years. This is calculated by:
Annual depreciation = Original purchase cost / Useful years
So in the case of this example the annual depreciation would be,
£400,000 / 10 years = £40,000
Therefore, we would reduce the value of the asset by £40,000 each year. 

Depreciation includes all the non cash charges deducted from debit dart except goodwill amortisation which is not added back to know clap because it was not deducted in calculating notepad the amortisation of other intangible assets such as patents and franchises are typically treated the same as goodwill

You will have noticed that we have not mentioned Amortisation as of yet.  The reason is that Amortisation is the same as depreciation, but it relates to the Non-physical and Intangible Assets e.g. trademarks or patents.  The concept and calculations are the same.

Where do you find depreciation in the financial forecast outputs?

Annual depreciation expense doesn't involve a movement of cash, it is a notional (non cash) charge.  However, the annual depreciation is still seen across the outputs

Income Statement – Annual depreciation is a charge, reducing the profit and you will see it under the EBITDA number as it is not an operational charge rather an accounting charge.

Balance sheet – The asset is the also reduced by the same annual depreciation amount to reflect the “netbook” or up to date value of the asset.

Cash flow – As it is a paper cost, we then add this charge back to the cash flow to reflect the real cash position, so it increases the operational cash flow.

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