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Depreciation: Three things lenders should know

There are three important issues around the topic of depreciation that, if you’re aspiring to become an astute lender, you should be aware of.

Depreciation is a real expense

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.

When CEOs tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.” 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 such as the debt to EBITDA ratio.

Yet, depreciation is a real expense for many businesses 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. So the inclusion of a depreciation figure in the income statement is an essential reflection of that need.

Where you should be worried is when the depreciation figure falls from year to year. That (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. That could enable those competitors to charge lower prices to customers and gain greater market share.
  • a continual increase in maintenance expenditure as the assets get older.

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 so as to optimise their productivity.

But accountants can be lazy. When an asset qualifies for this accelerated tax benefit, the accountant sometimes 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;

  • The depreciation figure in the income statement is higher than it should be. That’s because the asset is being depreciated too quickly. The result is that profits will be lower than they should.
  • The asset will disappear from the balance sheet when it is fully depreciated after a short period of time. Even though 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 as there will be no depreciation figure in the income statement. Then 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”. Manufacturing businesses might adopt the “units of production method” to depreciate their machinery and equipment. Technology businesses could use the “reducing balance method” for their hardware.

You should take careful note of which methods are being used to ensure that the methods are appropriate.. Also check 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 look at an example;

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. Employing the “straight-line method” results in 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.

  1. Increase the useful life of the asset from 5 years to (say) 10 years.  The annual depreciation charge would fall from 20,000 to 10,000. The new depreciable value would be 100,000 divided by 10 years. Thus increasing reported profit by the difference in the annual depreciation amount.
  • Increase the residual value from (say) 30,000 to 50,000. This would reduce the depreciable value to 80,000. That would result in the annual depreciation charge falling from 20,000 to 16,000 (80,000 divided by 5 years). And, again, that would result in an increase in reported profit.

Similar adjustments can be made using the other methods of calculating depreciation.  So the bottom line 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.

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