Depreciation

Post date: May 11, 2014 8:49:28 AM

In the last article we saw that depreciation is a dimension to be taken into account on the operational side and not on the financial side when computing operational cash flow. Now the question is how to assess depreciation.

The method of computing it is different on the type of asset but what is common for all assets is that they lose their value over time. How much of their current value lost can be considered part of the operating cash flow?

We will consider three commonly used methods to compute depreciation:

1. Straight line depreciation

The same percentage value gets depreciated every year based on the life span of the asset. In the end the book value for the asset will be zero when the depreciation is complete.

2.Double declining balance method

The straight line depreciation gets doubled and this double amount of the straight line depreciation is subtracted every year from the remaining value of the asset. This means that in the first years an asset depreciates its value heavily and less in the later years that come.

3.Sum of years digits method

The depreciable cost is computed as a fraction of the total life time of the asset and this leads to a more accelerated depreciation as in the straight line case but less than in the double declining method.

In this case if the life span of an asset is 3 years, the sum of years is 1 + 2 + 3 = 6 and the depreciation for each of the 3 years will be 3/6, then 2/6 and then 1/6 and this quantity will be subtracted each year from the remaining asset value.

In conclusion the first depreciation model will contribute to a relatively uniform operating cash flow over years while the double declining method will introduce fluctuations at this level from one year to the other. Depreciation plays an important role when computing operational cash flow and should not be disregarded.