What is Depreciation and How Does It Impact a Company's Valuation?
Depreciation is an expense that gradually decreases an asset's book value over its useful lifespan. It is different from typical expenses as it is a non-cash expense that is estimated years in advance. When a company buys an asset, its bookkeeper or CPA must determine its useful lifespan, salvage value, and depreciation methodology to calculate the annual depreciation amount over its useful life. It is essential for all financial analysts to understand the concept of depreciation as it appears in all three main financial statements: the income statement, balance sheet, and cash flow statement.
To understand how depreciation is calculated, let's consider an example. Suppose a company purchases factory equipment for $50,000 and plans to use it for the next four years. At the end of its useful life, the asset's market value, known as the salvage value, is estimated to be $10,000. To calculate the annual depreciation of the asset, we subtract the salvage value from the purchase price and divide it by the asset's useful life. The formula for this calculation is as follows:
(Purchase Price of the Asset - Salvage Value) divided by Useful Life
or
($50,000 - $10,000) divided by 4
resulting in
$10,000 of depreciation expense per year for 4 years
The expense of $10,000 would be reflected in the income statement. Additionally, the fixed asset account in the balance sheet would decrease by $10,000 annually. By the end of the fourth year, most of the equipment cost would be accounted for, and its book value would equal the salvage value of $10,000.
Why is Depreciation Important in Assessing a Company’s Value?
Depreciation is an important concept in accounting as it allows businesses to spread out the cost of an asset over its useful life instead of recording the entire cost in one year. This helps to ensure that the business's expenses are accurately matched with the revenue generated from the asset over time. By depreciating an asset, a business can reduce its taxable income, lowering its tax liability. Additionally, depreciation helps businesses recognize the decline in value of their assets over time, which is vital in assessing their financial position and deciding when to replace the asset.
Furthermore, depreciation affects a company's earnings and cash flow, which is essential for valuation analysis. Depreciation is a non-cash expense that reduces a company's reported earnings but does not affect its cash flow. Adjusting for depreciation can help assess a company's profitability and cash-generating ability. This is particularly important in industries where companies rely on significant investments in fixed assets, such as manufacturing or transportation.
In summary, understanding depreciation is crucial as it affects the book value of assets, earnings, and cash flow, which are key factors in a company's valuation analysis.