Depreciation, Amortization, and Capital Spending

Why this matters

Working capital covers gaps of weeks or months. Equipment, buildings, software, and acquisitions create gaps of years: the cash is spent once and the cost is recorded slowly afterward. For companies that own a lot of assets, the pace of that expense is one of the largest judgments in the income statement, and it's easy to overlook because no cash moves when it's recorded.

Spreading the cost

Money spent on assets that will be used for more than a year is a capital expenditure. It goes on the balance sheet as an asset. Each year a part of it moves to the income statement as depreciation, until the asset is carried at whatever the company expects to sell it for at the end.

The most common method is straight-line: the same amount every year.

Yearly depreciation = (cost − expected resale value) ÷ useful life in years

Two of those three inputs are estimates. Nobody knows how long a machine will really last or what it will fetch when it's replaced. Management chooses, within what's reasonable, and auditors review the choice.

A $12 million production line, no resale value	8-year life	12-year life
Depreciation each year	$1.5 million	$1.0 million
Profit before tax, compared with the 8-year case		$0.5 million higher
Cash spent	$12 million	$12 million

The machine and the cash are identical. Only the assumption differs. If the line really wears out after 8 years, the company that assumed 12 will have overstated its profit every year and will face a write-off at the end.

Companies state the useful lives they use, usually as ranges, in the first note to the financial statements. When two similar companies assume very different lives, their profits aren't directly comparable. When a company lengthens its assumed lives, profit rises without anything improving. A significant change is normally explained in the notes.

Capital spending against depreciation

STU Corp's numbers from Part 3 show how the pieces connect:

	This year
Balance at the start of the year	165
Capital expenditures	+40
Depreciation	−25
Balance at the end of the year	180

STU Corp spent 1.6 times its depreciation, so its asset base grew. Capital spending was 10% of its $400 million of revenue, and depreciation was about 6%.

The ratio of capital spending to depreciation is a quick reading of what a company is doing:

• Well above 1 usually means the company is expanding. STU Corp's revenue grew 14%, which fits.
• Close to 1 suggests it's replacing what wears out and little more.
• Below 1 for several years can mean the company is letting its assets age. Profit and free cash flow look good for a while, and then a large bill arrives.

Depreciation is based on what assets cost when they were bought, so after years of rising prices it can understate what replacing them will cost. Companies rarely say how much of their spending just maintains the business and how much is for growth. Depreciation is a common starting estimate for the maintenance part, and management's comments on its spending plans help refine it.

The rest of this lesson is for members

Still to come in this lesson: Amortization, goodwill, and impairment, The tax books are different, the key takeaways, and 2 quiz questions with explanations.

Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.

Become a member Sign in