Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2019 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.

Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Discussion on depreciation & interest charges - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks


Login Failure
(Please do not use this option on a public machine)
  Sign Up | Forgot Password?  

Discussion on depreciation & interest charges

May 7, 2009

In the previous article of this series, we had discussed how operating margins vary from one sector to another. In today's article, we will take a look at the items that come below operating profits- depreciation and interest. Depreciation: Overtime, assets lose their productive capacity due to reasons such as wear and tear, obsolescence, amongst others. As s result, their values deplete. Companies need to account for this depletion in value. This amount is called depreciation expense. Depreciation can also be viewed as matching the use of an asset to the income that it helped the company generate. It may be noted that it only represents the deterioration in value. As such, this expense is not a direct cash expense.

Depreciation can be accounted in broadly two methods straight line and written down value. The straight line value method divides the cost of an asset equally over its lifetime. An example will help us understand the process better. Suppose a company buys an equipment worth Rs 10 m in FY08, and it expects it to have a lifeline of 10 years, the depreciation rate would be 10% i.e. Rs 1 m (Rs 10 m * 10%). As such, the company will show depreciation charge (for that asset) as Rs 1 m each year.

Year Value of asset Depreciation amount
FY08 10,000,000 1,000,000
FY09 9,000,000 1,000,000
FY10 8,000,000 1,000,000
FY11 7,000,000 1,000,000
FY12 6,000,000 1,000,000
FY13 5,000,000 1,000,000
FY14 4,000,000 1,000,000
FY15 3,000,000 1,000,000
FY16 2,000,000 1,000,000
FY17 1,000,000 1,000,000
FY18 0 -

Under the written down value (WDV) method, companies depreciate the value of assets using a fixed percentage on the written down value. The written down value is the original cost less the depreciation value till the end of the previous year. As such, this results in higher depreciation during the earlier life of the asset and lesser depreciation in the later years. An example of the same is shown below:

A company buys an asset worth Rs 10 m in FY08. It will depreciate the value of the asset by 15% each year (on the written down value).

Year WDV of asset Depreciation amount
FY08 10,000,000 1,500,000
FY09 8,500,000 1,275,000
FY10 7,225,000 1,083,750
FY11 6,141,250 921,188
FY12 5,220,063 783,009
FY13 4,437,053 665,558
FY14 3,771,495 565,724
FY15 3,205,771 480,866
FY16 2,724,905 408,736
FY17 2,316,169 347,425
FY18 1,968,744 295,312

The main difference between both these methods is the actual amount of depreciation per year. However, it may be noted that the total depreciation costs (over the life of the asset) will be the same using either of the methods.

Coming to the point of how much depreciation a company charges, it mainly depends on the type of asset. As mentioned earlier, depreciation is charged on assets due to reasons such as obsolesce, wear and tear, amongst others. Fixed assets such as software and computers would be depreciated at the highest rate as they tend to get obsolete rapidly due to technology upgrades and updates. Plant and machinery would attract a lower depreciation rate due to their longer life. It may be noted that companies do mention the depreciation rates they take on their fixed assets in their annual reports.

Another point to be noted is that some companies show depreciation costs as part of operating expenses. However, it does not form part of the core operations of a company. As such, it would be a better method to calculate depreciation separately (after calculating the operating income) and not as part of the operating expenses.

Interest costs: Interest costs are the compensation that a company pays to banks or lenders for using borrowed money. These costs are usually expressed as an annual percentage of the principal, also known as the interest rate. As you may be aware, interest rate is dependent of variety of factors such as the credit risk of the company, time value of money, the prevailing global interest and inflation rates.

Any investor would prefer a company which is debt free. But that does not make companies that have a certain amount of debt a bad investment. If a company is easily able to cover its interest costs within a particular period, it could be a safe bet. How can we know that? This is where the interest coverage ratio comes in. The interest coverage ratio is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period.

For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20 m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the greater are the risks.

Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article

Equitymaster requests your view! Post a comment on "Discussion on depreciation & interest charges". Click here!

1 Responses to "Discussion on depreciation & interest charges"

Ramesh S

May 7, 2009

You have explained in detail how companies charge depreciation on their assets. I would like to know what happens to the depreciation amount shown in P&L statement, if the amount is deposited in bank accountearns any interest. Or is just a notional figure to boost up profit (by paying less tax). brPlease explai n.

Equitymaster requests your view! Post a comment on "Discussion on depreciation & interest charges". Click here!

More Views on News

BSE Sensex Surges 526 Points; YES BANK Among Top Gainers (Market Updates)

Jun 20, 2019 | Updated on Jun 20, 2019

Markets all time high analysis : The BSE Sensex Surged 526 Points; YES BANK Among Top Gainers. Find the latest update, special reports and news on all time high gainers of BSE Sensex at equitymaster.com.

Should An Equity Mutual Fund Scheme Hold High Cash Balances? (Outside View)

Jun 20, 2019

PersonalFN explains whether equity mutual funds hold cash balances.

Should You Invest In Sundaram Ultra Short-Term Fund For Your Short-term Needs? (Outside View)

Jun 20, 2019

PersonalFN briefly shares its views about recently launched debt scheme: Sundaram Ultra Short-Term Fund, an open ended scheme.

Does Your Stock Pass the Amazon Disruption Test? (The 5 Minute Wrapup)

Jun 20, 2019

The great global disruptor of our times has set its eyes on India. Are Indian businesses under threat from Amazon?

This Little-Known Opportunity Promises Both Health and Wealth for Your Grandchildren (Profit Hunter)

Jun 20, 2019

The next big opportunity that has the potential to make you both rich and healthy.

More Views on News

Most Popular

Investing in Share Market

Looking for investing in share market A few things you must know about share market and different ways of investing in the s...

7 Stocks That Will Remain Evergreen in this Era of Technological Disruption(The 5 Minute Wrapup)

Jun 13, 2019

We are living in an era of disruption. Are your stocks well equipped to adapt to changes that disruption will bring along?

The Great Indian NBFC Bubble Has Burst but I Will Still Recommend These Safe NBFCs(The 5 Minute Wrapup)

Jun 11, 2019

One chart that predicted the NBFC crisis back in 2016.

Kenneth Andrade Would Like Our Real Estate Stock Recommendation with Triple Digit Upside(The 5 Minute Wrapup)

Jun 12, 2019

This real estate stock recommended in Smart Money Secrets offers the most favourable upside potential.

Why Modi 2.0 Will Be Great for These 7 Stocks(Profit Hunter)

Jun 10, 2019

The government's focus on Infra, electricity, water for all will be the key factors for Sensex 1,00,000.


Get the Indian Stock Market's
Most Profitable Ideas

How To Beat Sensex Guide 2019
Get our special report, How to Beat Sensex Nearly 3X Now!
We will never sell or rent your email id.
Please read our Terms


Jun 20, 2019 (Close)