Depreciation and Amortization on the Income Statement
Investing Lesson 4 - Analyzing an Income Statement
By Joshua Kennon
The next topic we're going to discuss is depreciation and amortization on the income statement. Depending upon the type of business you are analyzing, depreciation and amortization charges can range from fairly inconsequential to enormously important in your understanding of profitability and the quality of the underlying economic engine. For asset-intensive businesses, management may have a lot of leeway in massaging the numbers to make performance look better or worse in any given period, causing reported net income to differ materially from owner earnings.
You're going to want to learn how to compare the depreciation and amortization policies of one firm against competitors; to look at how small or large they are relative to other businesses in the same sector or industry to see if anything looks askew.
You Need To Understand the Difference Between Depreciation Expense and Accumulated Depreciation
When you hear the word "depreciation", it's important to know what is being discussed. There are two different kinds of depreciation an investor must grapple with when analyzing financial statements. They are:
Depreciation Expense - The charges taken against revenue on the income statement, effectively lowering reported earnings, calculated using a number of different potential methods and with numerous assumptions. To provide a more precise explanation, according to one major brokerage firm, "Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred.”
Accumulated Depreciation - The aggregate accumulated depreciation charges taken over time against a specific asset that cause that asset to be reduced in value on the balance sheet to reflect its estimated lower value from wear, tear, use, and obsolescence. That is, when the depreciation expense we discussed a moment ago shows up on the income statement, instead of reducing cash on the balance sheet, it gets piled up in the accumulated depreciation account to lower the carrying value of fixed assets.
It may be easier to help you understand depreciation and amortization by walking you through a hypothetical illustration of how a fixed asset might be accounted for in the real world.
An Example of Depreciation Expense
Sherry’s Cotton Candy Company earns $10,000 profit a year. In the middle of 2015, the business purchased a $7,500 cotton candy machine that it expected to last for five years. If an investor examined the financial statements, he or she might be discouraged to see that the business only made $2,500 at the end of 2015 ($10,00 profit - $7,000 expense for purchasing the new machinery). The investor would wonder why the profits had fallen so much during the year.
Fortunately, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period the machinery is expected to benefit the company. Since the cotton candy machine is anticipated to last five years, Sherry can take the cost of the cotton candy machine and divide it by five ($7,500 / 5 years = $1,500 per year). Instead of realizing a single, lump sum one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows investors to get a more accurate picture of the company’s earning power.
The practice of spreading-out the cost of the asset over its useful life is depreciation expense. When you see a line for depreciation expense on an income statement, this is what it references; the period charges taken to reflect this sort of thing.
This presents an interesting dilemma. Although the company reported earnings of $8,500 in the first year, it was still forced to write a $7,500 check upright, effectively leaving it with $2,500 in the bank at the end of the year ($10,000 profit - $7,500 cost of machine = $2,500 remaining).
The result is that the cash flow of the company is different from what it is reporting in earnings. That matters a great deal because cash flow is very important. No matter what Sherry's profits appear to be at any given moment, she needs to have the liquidity on hand to pay her bills and operating expenses or else her business could fail.
In our scenario, the first year, Sherry’s would report earnings of $8,500 but only have $2,500 in the bank. Each subsequent year, it would still report earnings of $8,500 but have $10,000 in the bank because, in reality, the business paid for the machinery up-front in a lump-sum. This is vital because if an investor knew that Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of $8,500. In reality, the business would be $500 short.* There have been cases of companies going bankrupt even though they were reporting substantial profits. Do not underestimate this risk. If companies don't manage their growth intelligent, their prosperity can cause them to collapse.
This is where the third major financial report, the cash flow statement, comes into an investor's analysis. The cash flow statement is like a company’s checking account in that it shows how much cash was spent and generated, at what time, and from which source. That way, an investor could look at the income statement of Sherry’s Cotton Candy Company and see a profit of $8,500 each year, then turn around and look at the cash flow statement and see that the company really spent $7,500 on a machine this year, leaving it only $2,500 in the bank. There are some interesting opportunities for value investors and asset management companies to acquire certain assets that have enormous upfront fixed expenses, resulting in huge depreciation charges for assets that may not need to be replaced for decades resulting in far higher profits than the income statement alone would appear to indicate. These firms appear to trade at obscene price-to-earnings ratios, PEG ratios, and dividend-adjusted PEG ratios even though they aren't overvalued at all; sort of the opposite of a value trap.
Accounting for Depreciation Expense in Your Income Statement Analysis
Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying $1,500 a year, so the company should have added those back in to the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 figure. This is incorrect (honestly, I'm being polite - it's idiotic). Depreciation is a very real expense. In theory, depreciation attempts to match up profit with the expense it took to generate that profit to provide the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation expense will be apt to overvalue a business and find his or her returns lacking. As one famous investor quipped, the tooth fairy doesn't pay for a company's capital expenditure needs. Whether you own a motorcycle shop or a construction business, you have to pay for your machines and tools. To pretend like you don't is delusional. It will only harm you in the end so don't look for an excuse to do something stupid, letting your optimism override your good judgment.
*Depreciation expenses are deductible but the tax laws are complex. In many cases, a company will depreciate their assets to the IRS far faster than they do on their income statement, resulting in a timing difference. In other words, a machine may be worth $50,000 on the GAAP financial statements and $10,000 on the IRS tax statements. To adjust for this, accounting rules setup a special $40,000 "deferred tax asset" account on the balance sheet that will naturally work itself out by the time the asset has been fully depreciated down to scrap value. You don't really need to know that for now, but for those of you who get really excited about this sort of thing, I thought I'd throw it in there.