Depreciation and amortization: non-cash charges that matter

When a company buys a machine, a building or a patent, the benefit lasts for years, so accounting does not charge the whole cost in the year of purchase. Instead it spreads the cost over the asset's useful life. Depreciation does this for physical assets, and amortization does it for intangible assets with a limited life. Together, often shortened to D&A, they reduce reported profit every year even though no cash leaves the company that year.

What each term means

• Depreciation allocates the cost of tangible assets such as equipment, vehicles and buildings (land is not depreciated).
• Amortization allocates the cost of finite-lived intangible assets such as patents, licenses, acquired customer relationships and acquired technology. Capitalized software development costs are also amortized.
• Depletion is the similar charge for natural resources such as mines and oil and gas reserves.

Goodwill is different. Under US accounting rules, public companies do not amortize goodwill but test it for impairment instead. See goodwill and intangible assets.

Common methods

Straight-line spreads cost evenly:

Annual depreciation = (Cost - Salvage value) / Useful life in years

Accelerated methods, such as declining balance, charge more in the early years and less later, which suits assets that lose usefulness quickly. Units of production ties the charge to usage, such as hours run or units made.

Companies pick methods and estimate useful lives and salvage values for each asset class. The methods and ranges of useful lives are disclosed in the notes to the financial statements.

Example (illustrative numbers)

A company buys equipment for $1,000, expects it to last nine years and to be worth $100 at the end.

Annual depreciation = (1,000 - 100) / 9 = $100
After 3 years: accumulated depreciation = $300, net book value = $700

On the income statement, $100 of depreciation reduces operating income each year. On the cash flow statement, the same $100 is added back, because no cash is paid in those years. The cash left at the start, when the equipment was bought, and appeared as capital expenditure in that year.

Now see what an estimate can do. If management revises the useful life from nine years to twelve, annual depreciation falls to (1,000 - 100) / 12 = $75. Operating income rises by $25 a year on that equipment with no change in sales, costs or cash. That is why useful-life assumptions deserve a look when profit growth seems to come from nowhere.

Where D&A shows up

• Income statement. Often embedded in cost of revenue and operating expenses rather than shown as its own line.
• Cash flow statement. Shown as an add-back in operating activities. This is where to find the total amount.
• Balance sheet. Property, plant and equipment is shown net of accumulated depreciation, and intangibles are shown net of accumulated amortization.
• Notes. A table showing asset classes, useful lives and accumulated depreciation.

See how to read a cash flow statement for the add-back mechanics.

Why a non-cash charge still matters

It is tempting to dismiss D&A because it is non-cash. But the cash was spent when the asset was bought, and productive assets wear out and need replacing.

• It reflects real economic cost. A business that must keep buying equipment to stay in business is not "free" of that cost just because depreciation is non-cash. That is why EBIT charges for it and EBITDA does not.
• It links to capex. Depreciation is often used as a rough benchmark for the capital spending needed to maintain assets, though inflation and changing technology can make the true figure higher or lower. See capital expenditure.
• It explains the gap between profit and cash. D&A is a major reason operating cash flow often exceeds net income. See operating cash flow vs net income.

How to read it

Rules of thumb:

• Compare D&A with capex. Capex running well above D&A suggests a growing asset base. Capex well below D&A for a long time suggests aging assets or a shift to a lighter model.
• Compare D&A with revenue. The ratio indicates capital intensity and helps compare firms within an industry.
• Watch the trend. A sudden decline in D&A relative to the asset base can result from a longer useful-life estimate. A sudden jump can follow an acquisition that brought new intangibles to be amortized.
• Separate acquisition amortization. Amortization of intangibles bought in acquisitions is often excluded from "adjusted" earnings. It is non-cash and arises from past purchase prices, but it is also a sign of what was paid for growth.

Common mistakes and limits

• Equating D&A with true maintenance cost. Depreciation is based on historical prices and an estimated life, so it can understate or overstate the real cost of replacing assets.
• Ignoring tax differences. Companies often depreciate assets faster for tax purposes than in their reported accounts, which creates deferred tax items. Reported book depreciation is not the same as tax depreciation.
• Comparing across companies without checking policies. Different useful lives or methods affect margins for similar assets.
• Forgetting that fully depreciated assets can still work. An old machine with zero book value may still be productive, making profit look better than the economics of replacing it.
• Mixing the two. Amortization of acquired intangibles and depreciation of operating equipment carry different information.

Where to see it on StocksXray

Depreciation and amortization appear in the cash flow statement in the SEC filings linked from each stock page. The difference between EBIT and EBITDA in valuation multiples comes straight from this line.

Key takeaways

• Depreciation and amortization spread the cost of long-lived assets over their estimated useful lives.
• They reduce profit but not cash in the period, and are added back on the cash flow statement.
• Useful-life and method choices are estimates, and changing them moves reported profit.
• D&A is the link between capex, the balance sheet and profit, and the difference between EBIT and EBITDA.
• Read it alongside capital spending rather than dismissing it as non-cash.