Depreciation and amortization: Accounting tools investors need to know

Why Should You Care About This?

If you’re analyzing a company’s financial statements, you’ll notice mysterious figures called EBIT, EBITDA, and the phenomenon where asset values decrease each year. This is the story of depreciation and amortization.

These two concepts affect the net income reported by the company and are important for the lifespan of assets. If asset values are mismeasured, the company might make wrong decisions or, in severe cases, be forced to shut down.

What is (Depreciation)?

Brief Definition

Depreciation is the process accountants use to calculate the loss of value of tangible assets as the company uses them over time.

There are two sides to understand:

1. The Reality Side: Assets decrease in value over time (Cars will never get more expensive as they age)
2. The Accounting Side: The company must allocate the original cost of the asset over the expected useful years

The number of years used for calculating depreciation depends on the estimated useful life. For example, a laptop might be used for about 5 years. The financials will spread the original cost over those 5 years.

What assets can be depreciated?

Assets must meet these conditions:

• Owned by the company and used in operations
• Have a predictable useful life
• Expected to be used for more than 1 year

Common depreciable assets: Vehicles, buildings, office equipment, computers, machinery, and even some intangible assets like patents, copyrights, and software.

Assets that cannot be depreciated: Land (usually does not depreciate), collectibles (such as art, coins), stocks and bonds, personal property, or assets used for less than 1 year.

How does depreciation affect EBIT and EBITDA?

EBIT (Earnings Before Interest and Taxes) = Revenue before deducting interest and taxes

• When depreciation is calculated, EBIT decreases because depreciation expense is deducted from revenue

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) = Revenue before deducting interest, taxes, depreciation, and amortization

• EBITDA adds back depreciation, so this figure is always higher than EBIT

Why does this matter? When comparing two companies, one with many fixed assets and another with fewer, depreciation can make the first look worse. EBITDA helps remove this effect.

How to Calculate Depreciation: 4 Methods

1. Straight-Line Method(

Description: Divide the asset’s value equally over its useful life, deducting the same amount each year.

Advantages:

• Simple and easy to understand
• Suitable for small, uncomplicated businesses
• Reduces errors

Disadvantages:

• Does not account for faster depreciation in early years
• Does not consider increased maintenance costs as assets age

Example: Buying a car for 100,000 THB, expected to last 5 years → Depreciation of 20,000 THB per year

) 2. Double-Declining Balance###

Description: Accelerate depreciation at the start, then decrease it in subsequent years. This method speeds up cost recovery.

Advantages:

• Compensates for increased maintenance costs later
• Maximizes tax benefits in early years
• Suitable for businesses needing quick cash flow

Disadvantages:

• More complex
• If the company is loss-making, tax benefits may be lost

( 3. Declining Balance)

Description: Accelerated depreciation calculated at twice the straight-line rate. Expenses are higher in the first year and decrease over time.

Advantages:

• Assets appear more realistic in value

Disadvantages:

• More difficult to calculate

4. Units of Production(

Description: Depreciate based on actual usage, such as hours operated or units produced.

Advantages:

• Highly accurate, reflects actual usage
• Suitable for equipment with irregular use

Disadvantages:

• Difficult to track usage precisely
• Hard to estimate total production before the asset’s end of life

What is )Amortization( and How Is It Different from Depreciation?

) Main Difference

Amortization is the accounting process of spreading the cost of intangible assets or loans over time.

Examples:

• Amortization of an asset: Patent or machinery costing 10,000 THB with a 10-year life → 1,000 THB amortized annually
• Amortization of a loan: Borrowed 10,000 THB, repaid 2,000 THB annually → 2,000 THB amortized each year

When amortizing a loan

Initially, most of the monthly payment is interest. Over time, the principal decreases, and interest decreases as well. The monthly payment amount remains the same, but the interest-to-principal ratio changes.

( Intangible assets that can be amortized

Trademarks, patents, copyrights, and usually when acquiring an existing business.

Final Comparison: Depreciation vs Amortization

Why Do Investors Need to Know This?

When analyzing financial statements, depreciation and amortization impact:

• Reported net income (decreases)
• Company comparability (using EBITDA as reference)
• Investment decisions (not based solely on net profit)

Companies with many fixed assets tend to have high depreciation, which can make income look lower than it actually is. Using EBITDA provides a clearer picture.

Understanding depreciation and amortization helps you invest smarter and avoid being misled by accounting figures.