Depreciation and Amortization on the Income Statement
Performing income statement analysis for a company in which you'd like to invest helps determine the value and worthiness of the target. You'll likely run into some income statement items called depreciation and amortization, which some analysts classify as non-cash expenses, to be added back to net profit to arrive at a company's "true" earnings.
Depreciation and amortization charges can range from inconsequential to very important in your understanding of profitability and the quality of the underlying business operation.
Asset-intensive businesses may have a lot of leeway in massaging these numbers to make performance look better or worse by using different recording methods, causing reported net income to differ materially from owner earnings.
Understanding the basics of depreciation and amortization can better position you to interpret income statement results and a company's financial value.
Depreciation Expense Versus Accumulated Depreciation
There are two different kinds of depreciation an investor must understand when analyzing financial statements.
Depreciation Expense: Companies record the loss in value of their fixed assets through depreciation. Recording the depreciation as an expense over time spreads the initial cost of the fixed asset over the years of 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 shows up on the income statement, as a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred.”
Accumulated Depreciation: This account shows on the balance sheet and reflects the total depreciation charges taken to date against a specific asset, that cause that asset to be reduced in value. The reduced number reflects the wear, tear, use, and obsolescence of the asset. When depreciation expense shows up on the income statement, instead of reducing cash on the balance sheet, it gets added to the accumulated depreciation account to lower the carrying value of the relevant fixed assets.
The following example can help illustrate depreciation, amortization, and how fixed and intangible assets might be accounted for in the real world.
Depreciation Expense Example
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 - $7,500 expense for purchasing the new machinery). The investor would wonder why profits had fallen so much during the year.
Sherry’s accountants say that the $7,500 machine expense must be allocated over the entire period the machinery is expected to benefit the company. Since the cotton candy machine should 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).
Depreciating the Cotton Candy Machine
Instead of realizing a large one-time expense for the cotton candy machine in 2015, the company subtracts $1,500 depreciation each year for the next five years, reporting annual earnings of $8,500. This allows investors to get a more accurate picture of the company’s earning power.
When you see a line for depreciation expense on an income statement, this is what it references; the period charges taken to spread the cost of fixed assets over their useful lives.
This presents an interesting dilemma. Although the company reported earnings of $8,500 in the first year, it still wrote a $7,500 check for the machine, 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 cash flow of the company is subsequently different from what it reports in earnings. Regardless of Sherry's profits on paper, she needs to have the actual cash 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 because of the machine purchase.
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 all at once, with the difference being the $1,500 depreciation expense.
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.
An Amortization Example
Sherry's Cotton Candy Company had a busy year, and acquired the popular bakery, Milly's Muffins, which produced delicious baked goods and had a well-known reputation. After the acquisition, Sherry's added the value of Milly's baking equipment and other tangible assets to its balance sheet.
Sherry's also added the value of Milly's Muffin's name-brand recognition, an intangible asset, to the balance sheet as a line-item called Goodwill. The IRS allows a 10-year period to use up goodwill, so Sherry's accountants show 1/10 of the Milly's Muffins goodwill value as amortization expense on the income statement each year until the asset is entirely consumed.
Accounting Entries and Real Profit
Some investors and analysts 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 cash out of $1,500 a year, so the company should have added that depreciation figure back into the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 number.
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 may easily 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. Adding back depreciation expense to net profit ignores the real spending that took place.
Value investors and asset management companies sometimes acquire certain assets that have large upfront fixed expenses, resulting in hefty depreciation charges for assets that may not need to be replaced for decades. This results in far higher profits than the income statement alone would appear to indicate. These firms appear to trade at crazy price-to-earnings ratios, PEG ratios, and dividend-adjusted PEG ratios even though they aren't overvalued at all.