Depreciation

Why depreciation exists

A factory can produce goods for many years.

Charging the entire purchase price to one period would poorly match cost with the periods benefiting from the asset.

Depreciation spreads that cost across estimated useful life.

Straight-line example

Assume:

• machine cost: $1,000,000
• residual value: $0
• useful life: 10 years

Annual straight-line depreciation:

$100,000

After three years, accumulated depreciation would be approximately:

$300,000

and simplified net book value would be:

$700,000

before other adjustments.

Accumulated depreciation is not cash

Accumulated depreciation is a contra-asset balance.

It tracks depreciation recognized to date.

It is not:

• a cash reserve
• a replacement fund
• money set aside in a bank account

A company must still finance replacement assets when needed.

Depreciation is noncash today

Under the indirect cash-flow method, depreciation is commonly added back to net income because the expense reduced earnings without using current-period cash.

That does not erase the original capital outlay.

The cash usually left when the asset was acquired.

Depreciation vs. capital expenditures

Capex measures current investment in long-lived assets.

Depreciation measures current accounting allocation of prior capitalized cost.

A company can report:

• depreciation: $200 million
• capex: $500 million

The difference can reflect growth, replacement-cost inflation or catch-up investment.

Useful-life assumptions matter

A longer estimated useful life generally spreads cost over more periods and reduces annual depreciation.

A shorter life generally increases annual expense.

This can affect:

• operating income
• net income
• asset carrying value
• ROA

without changing current cash.

Real-world lives differ by asset

One 2026 filing disclosed straight-line useful lives such as:

• buildings: 20–25 years
• computer equipment and software: 2–6 years
• equipment and fixtures: 3–5 years.^[2]

Another company used different methods and lives for machinery and aircraft.^[3]

The appropriate estimate depends on the asset.

Depreciation affects operating margin

Depreciation can be included in:

• cost of sales
• operating expenses

depending on the asset and presentation.

Capital-intensive businesses can therefore show lower GAAP operating margins than asset-light businesses even when cash characteristics differ.

EBITDA removes depreciation

EBITDA adds depreciation back.

That can help compare companies with different asset ages and financing histories.

It can also make capital-intensive businesses look more cash-generative than they are if replacement capex is ignored.

ROIStreet’s GLS-051 — EBITDA and GLS-078 — Capital Expenditures should be read together.

Old assets can flatter returns

A company with heavily depreciated equipment can have a small net asset base.

That can make:

• asset turnover
• ROA
• ROIC

look stronger.

A competitor with newly replaced assets can report weaker ratios despite similar operating capability.

Asset age matters.

Common mistakes

"Depreciation is fake because it is noncash."

No. The current expense is noncash, but the underlying asset required capital.

"Depreciation equals maintenance capex."

No. They can differ materially.

"Accumulated depreciation is money saved for replacement."

No. It is an accounting contra-asset.

"Longer useful lives are always better."

They lower current expense but can overstate asset value if assumptions become unrealistic.

Depreciation can change even when physical assets do not

Depreciation expense can move because of:

• new asset purchases
• assets reaching the end of depreciable life
• changes in useful-life estimates
• changes in residual values
• asset disposals

The physical productive capacity of the business may change less than the accounting expense.

This is one reason trends in depreciation should be compared with gross property, plant and equipment and capital expenditures.

Fully depreciated assets can still be productive

A machine can reach a net book value near zero and continue operating for years.

That can make a mature company appear unusually asset efficient because the denominator in asset-based ratios is small.

Eventually, replacement can require a much larger cash outlay at current prices.

A high ROA or asset-turnover ratio built on old, heavily depreciated assets should therefore be interpreted alongside:

• asset age
• maintenance capex
• replacement plans

Book value records historical cost allocation, not replacement cost.

Review useful-life assumptions, depreciation methods, asset age, capex and impairment history. A noncash depreciation expense can still represent consumption of an asset that required real capital.