If you buy a car for yourself or a van for your business, it will wear out as it gets older and eventually need replacing. Your asset is therefore ‘depreciating’ over time. This depreciation needs to be reflected in a company’s accounts to allow for the wearing out of any assets in the accounting period. Profits are reduced a bit, and so is the value of the assets on the balance sheet.
Depreciation covers deterioration from use, age, exposure to the elements of obsolescence. There are several ways of depreciating the value of an asset. The ‘straight line’ method allows for a fixed and absolute amount of the value of the asset to be written off each year. ‘Reducing balance’ depreciation on the other hand, means that a set percentage of the remaining cost of the asset is written off each year.
Depreciation applies both to tangible property, like machinery and buildings, and to intangibles of limited life, like leaseholds and copyrights.
• See Tim Bennett’s video tutorial: Beginner’s guide to investing: the EV/EBITDA ratio.