Depreciation and Amortization on the Income Statement
If you'd like to invest in a publicly traded company, performing robust income statement analysis goes a long way in helping you determine the company's worthiness. And by specifically cultivating a keen understanding of income statement items known as "depreciation" and "amortization," you can uncover a company's true financial value.
Depreciation Expense Versus Accumulated Depreciation
There are two types of depreciation investors must understand when analyzing financial statements.
- Depreciation Expense: Companies record the loss in value of their fixed assets through depreciation. Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of machines, equipment, or vehicles it has purchased. Unlike other expenses, depreciation expenses show up on income statements as a "non-cash" charges, meaning that no money was actually paid when expenses were incurred.
- Accumulated Depreciation: This balance sheet item reflects the total depreciation charges taken to date when a specific asset drops in value due to wear and tear or obsolescence. When depreciation expenses appear on an income statement, rather than reducing cash on the balance sheet they are added to the accumulated depreciation account in order to lower the carrying value of the relevant fixed assets.
The following example illustrates depreciation, amortization, and how fixed and intangible assets might be accounted for.
Depreciation Expense Example
For the past decade, Sherry’s Cotton Candy Company earned an annual profit of $10,000. In 2015, the business purchased a $7,500 cotton candy machine expected to last for five years. An investor who examines the financial statements might be discouraged to see that the business made just $2,500 at the end of 2015 ($10,00 profit/$7,500 equipment expenses).
To counterpoint, Sherry’s accountants explain that the $7,500 machine expense must be allocated over the entire five-year period during when the machine is expected to benefit the company. Therefore, the cost should be divided by five: $7,500/5 years = $1,500 per year.
Instead of realizing a large one-time expense for 2015, the company subtracts $1,500 depreciation each year for the next five years, reporting annual earnings of $8,500. This gives investors a more accurate picture of the company’s earning power.
But this presents a 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. Therefore, the company's cash flow differs from its reported 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 her business may fail.
In our scenario, for the first year Sherry reports earnings of $8,500 but has $2,500 in the bank. Each subsequent year, she would still report earnings of $8,500 but have $10,000 in the bank because the business paid for the machinery in one lump sum.
An Amortization Example
In a very busy year, Sherry's Cotton Candy Company acquired Milly's Muffins—a bakery reputed for its delicious confections. 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 name-brand recognition, an intangible asset, as a balance sheet line-item called "goodwill." Since the IRS allows for a 10-year period to use up "goodwill," Sherry's accountants show 1/10 of the Milly's Muffins goodwill value as an 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 expenses should be added back into a company’s profits because it requires no immediate cash outlay. In other words: Sherry's 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 $8,500.
Depreciation is a very real expense. In theory, depreciation attempts to match up profit with the expense it took to generate that profit. An investor who ignores the economic reality of depreciation expense may easily overvalue a business and his investment may suffer.
The Bottom Line
Value investors and asset management companies sometimes acquire assets that have large upfront fixed expenses, resulting in hefty depreciation charges for assets that may not need replacement for decades. This results in far higher profits than the income statement alone would appear to indicate. Firms like these often trade at high price-to-earnings ratios, PEG ratios, and dividend-adjusted PEG ratios even though they aren't overvalued.