Depreciation and Cash Flow

Depreciation is a component of the cost of production, but it is a different type of cost.

To produce a product, a company may have to spend on materials, labor, and overheads. But it does not have to spend anything as depreciation. The spending has already taken place in the form of the cost of the asset.

Now, a portion of such cost is attached to the cost of production. Thus, a product’s cost consists of the current cost (e.g., cost of materials and labor) and the apportioned cost (depreciation) when a company recovers from the client the product cost plus profit.

Actually, the outgoings for the company are only the current costs of the product. Therefore, the amount collected toward depreciation and profit is available to the company in the form of liquid funds. This is known as operational fund flow.

Example

Suppose that a company manufactures a product at a cost of $200. This cost consists of the following:

  • Materials = $60
  • Labor = $40
  • Overheads = $60
  • Depreciation = $40

If the company sells the product at $280, then it will make a profit of $80 per unit.

However, the operational fund flow from the sale would be $120 because out of $280 collected from the customer, $160 will go towards the payment of current costs and, hence, the balance left is $120, which is equal to the profit plus depreciation.

As the company may have to pay tax on the profit of $80, the net operational fund flow can be said to be the gross operational flow less tax payable.

In the above example, assuming the tax to be 60% of the profits, the net operational fund flow would be $72.

The quantum of operational fund flow cannot be influenced by the depreciation method used. Any variation in the quantum of depreciation can influence the quantum of profit, but the depreciation and the quantum of profit put together will not change.

The policy regarding depreciation is framed at the top level of management. A decision on a method must be consistently followed and cannot undergo frequent changes.

Before making a final decision, the implications for tax payments, dividend distribution, cost flow, and other relevant factors must be fully analyzed.

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Frequently Asked Questions

What is a depreciable asset?

A depreciable asset is one that loses value over time. For tax purposes, a company can claim a Depreciation deduction for replacement of a depreciable asset. However, an intangible asset such as computer software does not qualify for Depreciation. It may be considered to have a useful life beyond the financial reporting period, and no Depreciation deduction is allowed.

What happens to depreciation when a company goes out of business?

In the event of a company going out of business, all assets (including depreciable assets) are sold and the proceeds are used to pay creditors. The remaining amount (if any) is distributed to shareholders.

How is depreciation calculated?

Depreciation is calculated by subtracting the salvage value from the original cost. In simple terms, it's a deduction to expense found in calculating net income. The total amount of depreciation over a period is divided by the useful life of an asset to produce a percentage rate called annual depreciation or straight line depreciation.

What happens to the salvage value?

The salvage value is the estimated amount a company would receive for an asset at the end of its useful life. It's important to note that the salvage value is not always received, as it may be sold or scrapped for less than expected. In either case, the depreciation expense is reduced by the amount of the salvage value.

What happens when an asset is sold?

When an asset is sold, any gain or loss is recognized as income or expense in the period the asset is disposed. The gain or loss is calculated by subtracting the proceeds from the original cost of the asset. If the proceeds are greater than the original cost, then the gain is recognized as income. If the proceeds are less than the original cost, then the loss is recognized as an expense.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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