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.
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.