Depreciation is often seen by lenders and analysts as something to be ignored because it’s not a cash expense but that’s really not the correct approach to this important element of a business.
In the last few posts I talked about depreciation as a concept and the main methods of calculating the annual depreciation figure. Today I’m going to look at the 3 key issues that lenders need to understand when dealing with the depreciation figure.
Depreciation is a real expense
“When CEOs tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak,” said Warren Buffett.
It’s very common for lenders and analysts to disregard depreciation simply because it doesn’t represent an outflow of cash. This especially happens when working with the EBITDA figure to calculate financial performance measures and other ratios such as debt/EBITDA.
Yet, for many businesses, depreciation is a real expense in that it’s a major element in the business’ cost of operations. For those businesses, especially in industries such as mining, manufacturing and transport, the need for capital equipment is integral to the business being able to operate and so the inclusion of a depreciation figure in the income statement is an essential reflection of that need.
Where lenders and analysts should be worried is when the depreciation figure falls from year to year which (assuming no change in depreciation policy) would tend to suggest that the business is not replacing fixed assets on a regular basis. The result of that strategy will almost certainly be a fall-off in productivity due to older technology being utilised, a potential loss in market share if its competitors are acquiring newer technologies which enable them to be more price competitive and a continual increase in maintenance expenditure.
Depreciation is an accounting expense, not a tax expense
In some jurisdictions (South Africa for one), businesses are able to claim accelerated tax breaks on certain types of capital expenditure. This is to encourage them to replace capital equipment regularly and to optimise their productivity.
But, accountants can be lazy. When an asset qualifies for this accelerated tax benefit, sometimes the accountant depreciates the asset over the same time period. The problem with this is that the asset may have a useful life well beyond this accelerated time frame.
Doing this has two effects. One is that the amount of depreciation in the income statement is to some degree overstated because the asset is being depreciated too quickly with the result that profits can be lower than they would otherwise be because the amount of annual depreciation is a larger proportion of the asset’s value.
The second effect is that the asset will disappear from the balance sheet when it is fully depreciated after a short period of time although it may continue to be used in the business to generate revenue and/or profit for some years afterwards. The result of this is that profits in subsequent years will likely be overstated and any ratios that are calculated using a total assets figure will be distorted because the asset figure will be lower than it really should be.
The presence of a figure for deferred taxation in the balance sheet of a business is a good indicator that this issue is not happening as that figure most commonly results from the temporary difference the tax value and the accounting value of an asset.
Depreciation is a good way to manipulate profits
The depreciation methodology that a business adopts can vary from asset to asset depending on its type and purpose. By far the most common is the straight-line method but manufacturing businesses might also adopt the units of production method to depreciate their machinery and equipment while technology business could use the reducing balance method for their hardware, for example.
Lenders and analysts should take careful note of which methods are being used for which assets to ensure that the methods are appropriate and that the depreciation period and residual value don’t change during ownership of the asset. This last point is to identify any profit manipulation that might be taking place. Let’s consider a couple of examples;
A business purchases an asset for 130,000 and decides that the residual value after 5 years will be 30,000. The depreciable value is therefore 100,000 which requires an annual depreciation charge of 20,000 a year for 5 years.
A few months later the business isn’t doing too well and would like to improve its reported profits. There are 2 ways to do this using the depreciation calculation.
- Increase the useful life from 5 years to (say) 10 years. This is a somewhat extreme scenario but the annual depreciation charge would fall from 20,000 to 10,000 (depreciable value of 100,000 divided by 10 years) thus increasing reported profit by the difference.
- Increase the residual value from (say) 30,000 to 50,000. This would reduce the depreciable value to 80,000 which would result in the annual depreciation charge falling from 20,000 to 16,000 (80,000 divided by 5 years), again increasing reported profit.
Similar adjustments can be made using the other methods of calculating depreciation. So the bottom line for lenders and analysts is that depreciation is very real and should be investigated carefully so as not to overlook this very important expense that reveals much about the business.