Depreciation and amortisation
Spreading the cost of something you bought once across the years it is useful. Dull, non-cash, and quietly responsible for a great deal of accounting mischief.
A company buys a machine that will run for ten years. Charging the whole cost against one year's profit would make that year look terrible and the next nine look wonderful, neither of which describes the business. So the cost is spread.
The two words
- Depreciation applies to physical assets: buildings, machinery, vehicles, servers.
- Amortisation applies to intangible assets with a defined life: acquired patents, customer lists, software licences.
The mechanism is identical. The distinction is only what is being written down.
A $10m machine with an expected ten-year life and no resale value is depreciated at $1m a year. After four years, the balance sheet shows the machine at $6m — its cost less accumulated depreciation. That $6m is a bookkeeping figure, not an estimate of what the machine would fetch.
The judgements inside it
Two estimates drive the whole charge: how long the asset will be useful, and what it will be worth at the end. Both are set by management.
Extending the assumed life of a $10m asset from ten years to twenty halves the annual charge to $500,000, adding $500,000 to pre-tax profit every year. Cash is unaffected. The change must be disclosed in the footnotes, and it is a change investors very rarely notice. See reading the footnotes.
Why EBITDA adds it back
EBITDA — earnings before interest, tax, depreciation and amortisation — strips these charges out. The rationale is that they are non-cash and driven by past decisions, so removing them shows current operating performance.
That is fair for comparing two companies with different asset ages, and it is a trap in one specific case.
A haulage company's trucks wear out and must be bought again. EBITDA excludes the wearing out, so a business that will spend heavily on replacement looks like one that will not. For capital-intensive businesses, depreciation is an approximation of a real, recurring, unavoidable cost — and calling it non-cash describes the timing, not the obligation.
The check that settles it
Compare annual capital expenditure with annual depreciation over five years, both visible on the cash flow statement.
- Capex consistently above depreciation — the company is growing its asset base, or its old assets were cheaper than replacements. Investigate which.
- Capex consistently below depreciation — the asset base is shrinking. Sometimes that is a business becoming less capital-hungry. More often it is under-investment, and the bill arrives later.
- Capex roughly equal to depreciation — the accounting charge is a reasonable proxy for what maintaining the business costs, and EBITDA is overstating earnings by about that amount.