A Weekly Business Finance series for Non-Finance Executives!
“Financial Adrenaline” is a term we love around here because it reflects our commitment to help you turbocharge your business with practical tips and techniques to improve free cash flow, the lifeblood of business. As a further extension of our Financial Adrenaline program, we’re going to share a new Business Finance Tidbit every Wednesday specifically for those business executives who don’t have a finance background.
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Depreciation = Cash? Why do we care?
We’ve kinda been on a Warren Buffett tear lately, and last week I encouraged you to read his recent 2010 Annual Report to Berkshire Hathaway shareholders.
I want to plant another seed this week about an often misunderstood concept: [kastooltip msg=”DEPRECIATION” tooltip=”In accounting, an expense recorded to allocate a tangible asset’s cost over its useful life. Because depreciation is a non-cash expense, it increases free cash flow while decreasing reported earning. It is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. For example, if a company buys a piece of equipment for $1 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense $100,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year.”]. (You can see the definition by placing your cursor over the term.)
How is Depreciation Relevant to EBITDA?
Today, let’s just think about it in terms of EBITDA. In Does EBITDA Bury Its Own Dead?, I wrote about the perils of treating EBITDA as a placeholder for cash flow, and Buffett couldn’t agree more.
In his Annual Letter to Shareholders, 2002, Buffet describes how depreciation is viewed by those devoted EBITDA followers … as a non-cash item that is unimportant to cash flow as part of the EBITDA cash flow legend
In future columns, we’ll address the way the depreciation is viewed, the conflicting signals it sends and the issues it conceals. In the meantime, Buffett goes on in his 2002 letter to further attack the concept that depreciation isn’t a real expense, which he calls “nonsense”.
Consider this Analogy … Depreciate Your People?
Buffett offers an interesting analogy that I hadn’t considered, but it’s a poignant way of looking at depreciation as a most deceiving member of this EBITDA tribe:
“In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”
What do you think? Are you staring at your EBITDA numbers every month? Can we help you understand it better?
I find the suggestion as treating compensation paid in advance as a non cash expense recognized in the future as quite unique. Using the analogy of fixed assets and depreciation is a great way of presenting your case, but I would be pretty hard pressed to adopt this methodology for any company that I would be involved in. I actually may use this discussion in a presentation I am doing tomorrow for a non profit group.
Wayne – I agree that Buffett’s comment represents a unique concept. In context, I think he was trying to make the point that it’s just as absurd to think of depreciation as not being a “real expense” by those who rely on EBITDA as it would be to think that depreciating prepaid “people costs” was not a “real expense”.