Depreciation, amortisation and capital expenditure

In simple terms

Some spending is used up quickly: electricity, salaries, raw materials. Other spending buys things that last for years: a factory, a delivery van, a computer system. Accounting treats the two differently.

• Operating expenses are used up within the year, so they reduce that year's profit straight away.
• Capital expenditure, often shortened to capex, buys long-lived assets. It is recorded as an asset on the balance sheet, and its cost is then spread over the years the asset is used.

That spreading is called depreciation for physical assets such as machines and buildings, and amortisation for intangible assets such as software, licences and patents. Land is usually not depreciated, because it does not wear out.

Straight-line depreciation

The simplest and most common method charges the same amount every year.

Some companies use the written-down value method instead, which charges a fixed percentage of the remaining book value each year: more depreciation in the early years and less later. At 20% a year, the same ₹50 lakh machine would be depreciated by ₹10 lakh in year one, ₹8 lakh in year two and ₹6.4 lakh in year three. The method and the useful lives a company uses are listed in its accounting policies.

Amortisation

Intangible assets have no physical form but still last for years: a mobile network licence, a patent, software built for internal use, customer contracts acquired with another company. Their cost is spread over their useful life as amortisation, in the same way as depreciation. Some intangible assets, such as goodwill from an acquisition, are not amortised under Ind AS, the accounting standards most listed Indian companies follow; instead they are tested every year for a fall in value, which the provisions and impairments lesson explains.

Depreciation is a non-cash cost, but a real one

Depreciation reduces profit without any money leaving the bank that year: the cash left when the asset was bought. That is why depreciation is added back when working from profit to cash flow, and why measures such as EBITDA leave it out.

But the cost is real. Machines wear out, computers become obsolete and vehicles need replacing, and replacing them takes cash. A business that needs to spend ₹100 crore every few years to stay in business is not as profitable as one that does not, even if their profits before depreciation look the same. Over a long period, a stable company's capital expenditure tends to be at least as large as its depreciation; a growing one usually spends more.

When expenses are dressed up as assets

Because capital spending reaches the income statement only slowly, a company can make its profit look better by treating ordinary running costs as capital spending, a practice called capitalising expenses.

Warning signs include capital spending that is persistently much higher than depreciation without matching growth in sales, and large amounts of "capital work in progress" that never seem to be completed.

Why it matters

Depreciation and amortisation sit between EBITDA and operating profit in every income statement, and capital expenditure is one of the largest uses of cash in many businesses. Understanding them explains why profit and cash differ, why heavy-industry businesses can look profitable while generating little spare cash, and why "add back depreciation" arguments need care.

Limitations

• Useful lives and residual values are estimates chosen by management. Longer lives mean lower yearly charges and higher profit.
• Depreciation is based on what an asset cost, not what it would cost to replace today, which can be far higher after years of inflation.
• Comparing companies that use different depreciation methods or lives requires adjusting for the difference.

Common mistakes

• Saying depreciation "doesn't matter because it isn't cash". The cash was spent when the asset was bought, and will be spent again to replace it.
• Treating EBITDA as profit. It ignores the cost of the assets the business uses up.
• Ignoring changes in useful lives. A company that suddenly extends asset lives has raised its profit without improving the business.
• Forgetting that capex is a cash outflow even though it does not appear as an expense.

Try it yourself

1. In an annual report, find the note on property, plant and equipment, which lists assets, their depreciation and the useful lives used.
2. Compare the year's depreciation charge in the income statement with the year's capital expenditure in the cash flow statement ("purchase of property, plant and equipment").
3. Over the past five years, has capital expenditure been higher or lower than depreciation? What might that say about the business?