Advertisement

Depreciation

If you buy an asset, it will wear out as it gets older and eventually need replacing. It is therefore 'depreciating' over time.

Updated August 2018

If you buy a van or a photocopier or any other piece of equipment for your business, then it will wear out as it gets older, and it will eventually need to be replaced. The asset is therefore "depreciating" in value 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. There are several ways of depreciating the value of an asset.

Advertisement - Article continues below

The "straight line" method allows for a fixed 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. In each case profits are reduced a bit, and so is the value of the assets on the balance sheet.

Note that this is separate from cash flow depreciation does not reflect cash coming in or out of the business, but rather a change in the value of its assets.

Depreciation applies to tangible property, such as machinery and buildings. When applied to intangible assets such as goodwill arising from an acquisition (goodwill effectively represents the excess over and above book value that one company has paid for another in other words, the amount paid for "hidden" assets such as a leading brand) the term used is amortisation.

Depreciation and amortisation policies can sometimes be used to flatter profit figures (or to reduce them for tax-efficiency purposes), which is why it pays to look closely at measures such as cash flow as well as profit before deciding whether to invest in a particular company.

It also explains why many analysts use Ebitda earnings before interest, taxes, depreciation and amortisation in their valuation calculations, so as to avoid distortions arising from accounting policies.

See Tim Bennett's video tutorial: Beginner's guide to investing: the EV/EBITDA ratio.

Advertisement
Advertisement

Recommended

Visit/glossary/technical-analysis
Glossary

Technical analysis

Technical analysts or 'chartists' attempt to predict future share price (or index) movements by looking at past movements.
5 Jun 2020
Visit/glossary/bonds
Glossary

Bonds

A bond is a type of IOU issued by a government, local authority or company to raise money.
19 May 2020
Visit/spending-it/glossary/601300/quantitative-investing
Glossary

Quantitative investing

Quantitative investing uses sophisticated computer-based mathematical models to identify and carry out trades.
8 May 2020
Visit/glossary/quantitative-easing-qe
Glossary

Quantitative easing (QE)

Quantitative easing (QE) involves electronically expanding a central bank's balance sheet.
8 May 2020

Most Popular

Visit/investments/commodities/gold/601444/these-seven-charts-show-exactly-why-you-must-own-gold-today
Gold

These seven charts show exactly why you must own gold today

Covid-19 is accelerating many trends that were already in existence. The rising gold price is one such trend. These seven charts, says Dominic Frisby,…
3 Jun 2020
Visit/investments/stockmarkets/601460/disease-rioting-and-mass-unemployment-so-why-are-markets-soaring
Stockmarkets

Disease, rioting and mass unemployment – so why are markets soaring?

Despite some pretty strong headwinds in the last year, America’s S&P 500 stock index is close to all-time highs. John Stepek explains why markets seem…
4 Jun 2020
Visit/economy/eu-economy/601463/why-a-stronger-euro-is-good-news-for-investors
EU Economy

Why a stronger euro is good news for investors

The fragile state of the eurozone has for a long time brought the threat of deflation. But the ECB’s latest moves have dampened those fears. John Step…
5 Jun 2020