# 3.1.9. Depreciations

Depreciation corresponds to the loss of value of an asset through its life time. To illustrate it, think of a car that you have purchased as new. Over time it will lose its value. The depreciation corresponds to the allocation of that loss of value over the car’s useful life. This concept can be applied to any asset that you can think of.

You should be aware that depreciation is a loss that the company sustains, but it does not correspond to a cash flow: you have already paid for the asset in the beginning when you acquired it, so you are only accounting its loss of market value. It is a non-cash cost, thus meaning that it affects directly your net profit but not the cash flows of the company. It does affect the cash flow of the company indirectly as it influences the corporate tax paid.

###### Example – How depreciations affect the income statement understanding

Take the following example of companies XAB and BAX. XAB holds depreciating assets and whereas BAX does not. All else is equal (this is a very simplified example to illustrate why depreciations are non-cash costs).

 Company XAB BAX Net revenue 25.000 25.000 Operating expenses 15.000 15.000 EBITDA 10.000 10.000 Depreciation 2.500 0 EBIT 7.500 10.000 Interest costs 0 0 EBT 7.500 10.000 Corporate tax (30% rate) 2.250 3.000 Net profit 5.250 7.000

Despite BAX having had a higher net profit it, you should notice that cash earned by XAB is higher:

• Both companies earned 10.000 from operations. XAB registered depreciations, but this does not correspond to money spent. XAB had to pay 2.250 in corporate tax and BAX 3.000.
• XAB cash balance is 5.250
• BAX cash balance is 7.000

This simple illustration of non-cash costs will be further demonstrated on the feasibility analysis handbook.

The picture below explains the dynamics of depreciation. When you acquire an asset the value after depreciation is equal to its gross value. But, as years go by the value of the asset diminishes because it is depreciation is accumulated along the years. At the end of the depreciation period, the value of the asset is zero and the accumulated depreciation is equal to gross value. How shall an asset be depreciated?

It depends on the asset, but the main stream approach states that it should be depreciated along its predictable useful life span. There are a different methods used to calculate depreciation:

• Straight-line depreciation (system used by CASFLO APP)
• Declining balance and sum of the years’ digits.

Straight line depreciation depreciates a fixed asset over its expected life. The following are required:

1.       The cost of the asset.

2.       Its expected useful life.

3.       Its residual value (the price an asset is expected to sell for at the end of its useful life).

###### Example – Depreciation calculated through straight line

Company XAB bought a machine for 75.000€ on January 1st and knows that its expected useful life is of five years and that it may be able to sell the machine for 15.000€ (the residual). The yearly depreciation of the machine is 12.000€:

Depreciation=(Initial cost-residual value)/(number of years of expected life)= (75.000-15.000)/5=12.000

 Year 1 2 3 4 5 Gross value 75 75 75 75 75 Annual depreciation 12 12 12 12 12 Accumulated depreciation 12 24 36 48 60 Net value (at year end) 63 51 39 27 15

There are two important things you need to be aware of:

1. Most times, accountants do not consider any residual value as it is assumed that the asset will be fully used by the company. Thus, the asset will be fully depreciated.
2. Although it is assumed as the number of years that the asset will last, depreciation is usually calculated on a monthly basis. An asset bought in July will be depreciated by half of its yearly depreciation value (corresponds to 6 months of depreciation).

CASFLO APP uses a straight-line depreciation method under a monthly basis. It does not compute a residual value.

The declining balance method applies a depreciation rate that is higher in the earlier years of the useful life of an asset.

Below you may find a suggestions for the depreciations rates that could be used. Although each case is a case and you should always adjust the depreciations rates to the wear of an item.

 Type of item Depreciation rate Land 0,00% Industrial buildings 5,00% Services and residential buildings 2,00% Light machinery 20,00% Heavy machinery 12,50% Electronic equipment 20,00% Precision and lab instruments 14,28% Office equipment 20,00% Furniture 12,50% Computers 33,33% Software 33,33% Mobile phones 20,20% Passenger vehicles 25,00% Trucks and cargo vehicles 20,00%

Depreciation rates are commonly regulated for tax purposes, either by setting directly the depreciation rate or by referring in which percentage intervals the depreciation rate may be set. You should always look for the accurate depreciation rate.

Next Section: 3.1.10. EBIT