A high percentage of depreciation would result in the earnings of the company falling below expectations if their operations had been profitable.

Depreciation is the cost of the asset minus the estimated residual value of the asset / Life of assets. Any change in the cost, the residual value, or the life of the asset will change the amount of depreciation.

There are two methods to calculate depreciation. One is the straight-line method and the other is the written down value method. Any change in depreciation policy can have a huge positive or negative impact on the profits.

As an investor it enough to know the following points:

· Depreciation is an expense

· Being a non-cash expense, no outflow of cash is involved.

· The decision of a company on the method of depreciation affects the outcome of the balance sheet.

· As depreciation plays an important role in determining the figures on the balance sheet of the company, it affects the profit on the income statement. These documents are of paramount importance in determining the shareholder returns and the creditworthiness of the company.

· Increase in depreciation also indicates that the company has procured new assets. Companies having high growth, on the path expansion acquire several assets in the form of machinery or fixed assets. To this extent, it is also a positive sign.

· A fall in profits because of an increase in depreciation expenses need not be considered a negative sign if the increased depreciation amount is due to acquiring fixed assets.

· One has to be careful if the material change in depreciation figures is because of charging the depreciation rates or because of changes in the method of calculating depreciation.

· As depreciation is an expense that depends on many factors, and investors consider the Profit Before Deprecation and Taxes, in their valuation.

· Amortization and depletion are expenses that are similar to depreciation and are non-cash in nature.

· Amortization is exactly like depreciation, for an intangible asset. We know that businesses may have tangible assets like plant and machinery or intangible assets like patents, goodwill, etc. When the company writes off tangible assets at a specific rate, it is called depreciation and when writing off intangible assets, it is called amortization.

· Depletion is the allocation of the cost of natural resources over some time. Like an oil well for example which has a finite life before the entire oil is pumped out. This being the case, the setup cost of the oil well is spread over the estimated life of the oil well.

· As these are non-cash expenses, the above three items decrease the earnings of the company but at the same time helps in increasing the cash flow of the company.

· This has considerable effects on tax commitment. Although a company claiming less depreciation/amortization may seem more profitable, it will be taxed more. Short-term tax relief can be got by opting for a higher depreciation percentage.

Where to find

Information on depreciation is found in the schedules to the balance sheet and notes in the annual report or quarterly results of the company. The method and rates of depreciation are found in the schedule on ‘Significant Accounting Policies’. Other accounting practices specific to the company are found in notes to accounts.