Summary
Depreciation is the gradual allocation of the cost of a tangible asset over its useful life. Tangible assets may include buildings, equipment, vehicles, or machinery.
Depreciation reduces accounting profit but does not represent a cash payment in the period it is recorded.
Why it matters
Depreciation helps match the cost of long-term assets with the periods in which they are used. Investors review depreciation because it affects reported profit and is added back in cash flow analysis.
It is also relevant when assessing capital-intensive businesses.
How to Calculate it
Depreciation Expense = (Asset Cost – Residual Value) ÷ Useful Life
Where:
- Asset Cost= Original purchase price of the asset
- Residual Value= Expected value of the asset at the end of its useful life
- Useful Life= Number of years the asset is expected to be used
How to read it
Higher depreciation may indicate significant investment in physical assets. It can reduce net income even though it does not directly reduce cash in the same period.
Investors should review depreciation together with capital expenditure, asset base, and cash flow.