There are two different kinds of depreciation an investor must grapple with when analyzing financial statements. They are accumulated depreciation and depreciation expense. Each is unique, though new investors often confused them. In order to understand why they are important and how they work, we must discuss the terms individually.
According to a major brokerage firm, “Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred.”
An Example of Depreciation Expense
To help you understand the concept, let’s look at an example of depreciation expense:
Sherry’s Cotton Candy Company earns $10,000 profit a year. In the middle of 2002, the business purchased a $7,500 cotton candy machine that it expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 ($10k profit - $7.5k expense for purchasing the new machinery). The investor would wonder why the profits had fallen so much during the year.
Fortunately, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it will benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five ($7,500 / 5 years = $1,500 per year). Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows investors to get a more accurate picture of how the company’s earning power. The practice of spreading-out the cost of the asset over its useful life is depreciation expense. When you see a line for depreciation expense on an income statement, this is what it references.
This presents an interesting dilemma. Although the company reported earnings of $8,500 in the first year, it was still forced to write a $7,500 check, effectively leaving it with $2500 in the bank at the end of the year ($10,000 profit - $7,500 cost of machine = $2,500 remaining).
The result is that the cash flow of the company is different from what it is reporting in earnings. The cash flow is very important to investors because they need to be ensured that the business can pay its bills on time. The first year, Sherry’s would report earnings of $8,500 but only have $2,500 in the bank. Each subsequent year, it would still report earnings of $8,500, but have $10,000 in the bank because, in reality, the business paid for the machinery up-front in a lump-sum. This is vital because if an investor knew that Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of $8,500. In reality, the business would be $500 short.* There have been cases of companies going bankrupt even though they were reporting substantial profits.
This is where the third major financial report, the cash flow statement, comes into an investor's analysis. The cash flow statement is like a company’s checking account. It shows how much cash was spent and generated, at what time, and from which source. That way, an investor could look at the income statement of Sherry’s Cotton Candy Company and see a profit of $8,500 each year, then turn around and look at the cash flow statement and see that the company really spent $7,500 on a machine this year, leaving it only $2,500 in the bank. The cash flow statement is the focus of Investing Lesson 5.
Accounting for Depreciation Expense in Your Income Statement Analysis
Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying $1,500 a year, so the company should have added those back in to the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 figure. This is incorrect (honestly, I'm being polite - it's idiotic). Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation expense will be apt to overvalue a business and find his or her returns lacking. As one famous investor quipped, the tooth fairy doesn't pay for a company's capital expenditure needs. Whether you own a motorcycle shop or a construction business, you have to pay for your machines and tools. To pretend like you don't is delusional.
*Depreciation expenses are deductible but the tax laws are complex. In many cases, a company will depreciate their assets to the IRS far faster than they do on their income statement, resulting in a timing difference. In other words, a machine may be worth $50,000 on the GAAP financial statements and $10,000 on the IRS tax statements. To adjust for this, accounting rules setup a special $40,000 "deferred tax asset" account on the balance sheet that will naturally work itself out by the time the asset has been fully depreciated down to scrap value. You don't really need to know that for now, but for those of you who get really excited about this sort of thing, I thought I'd throw it in there.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.