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, among others. As a 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 per cent, that is, Rs 1 m (Rs 10 m * 10%). As such, the company will show depreciation charge (for that asset) as Rs 1 m each year.
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).
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 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.
This article is authored by > Equitymaster.com , India’s leading independent equity research initiative
Disclaimer: The opinions expressed by Equitymaster are theirs alone and do not reflect the opinions of The Hindu Business Line or any employee thereof. The Hindu Business Line is not responsible for the accuracy of any of the information within the article.