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Depreciation & Amortization (D&A)

$$\text{Annual Depreciation} = \frac{\text{Asset Cost} - \text{Salvage Value}}{\text{Useful Life (years)}}$$

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What is Depreciation & Amortization (D&A)?

Depreciation is the systematic allocation of a tangible asset's cost over its useful life. When a company buys a machine for $500,000 with a 10-year useful life, it records $50,000 of depreciation expense each year rather than expensing the full cost immediately. Amortization is the same concept applied to intangible assets: patents, customer lists, trademarks, and software.

D&A is a non-cash charge: it reduces reported profit on the income statement without any cash leaving the business in that period. The cash left when the asset was purchased. This is why analysts add D&A back to Net Income when calculating EBITDA - to reveal cash-generative ability without the distortion of accounting depreciation schedules.

The choice of depreciation method (straight-line vs. accelerated) affects how quickly an asset's cost is expensed. Straight-line spreads the cost evenly. Accelerated methods (like double-declining balance) front-load depreciation, which reduces reported profit in early years and increases it later. Two companies with identical assets can report very different profits depending on their depreciation method.

When to use Depreciation & Amortization (D&A)

Pay close attention to D&A when comparing EBITDA vs EBIT: the gap between them equals D&A. Asset-heavy businesses (telecom, manufacturing, oil & gas) have large D&A charges, making EBITDA much higher than EBIT - and therefore making EBITDA-based valuation look cheaper than EBIT-based valuation. Also track whether annual D&A approximates CapEx - if CapEx consistently exceeds D&A, the company is growing its asset base.

Worked examples for Depreciation & Amortization (D&A)

This table quickly gives you the overview you need to understand Depreciation & Amortization (D&A) and its most important comparisons.

Asset	Cost	Useful life	Annual depreciation (straight-line)	Method
Manufacturing machine	$500,000	10 years	$50,000	Straight-line
Office building	$2,000,000	40 years	$50,000	Straight-line
Customer list (intangible)	$300,000	5 years	$60,000	Amortization
Software licence	$120,000	3 years	$40,000	Amortization

Common pitfalls

D&A is a real economic cost even though it is non-cash. An asset that depreciates to zero must eventually be replaced - often at a higher cost. Treating EBITDA as a synonym for free cash flow ignores this CapEx requirement. This is especially relevant in capital-intensive industries where D&A understates replacement cost.

Frequently asked questions about Depreciation & Amortization (D&A)

Why is D&A added back to calculate EBITDA?

Because D&A is a non-cash charge - it reduces accounting profit without reducing cash. Adding it back to Net Income gives a closer approximation of the cash profit generated by operations before interest and tax.

What is the difference between depreciation and amortization?

Depreciation applies to tangible assets (equipment, buildings, vehicles). Amortization applies to intangible assets (patents, customer relationships, software). The mechanics are the same - both allocate an asset's cost over its useful life.

Can depreciation be accelerated for tax purposes?

Yes. Most tax authorities allow accelerated depreciation for tax reporting, meaning a company can deduct more depreciation in early years for tax purposes than it records in its financial statements. This creates a deferred tax liability on the balance sheet.

Test your knowledge

Quiz: how well do you know depreciation and amortization?

5 questions · ~2 min

1. What does depreciation represent in accounting?

ℹ Depreciation allocates a tangible asset's cost over its useful life. A $500,000 machine with a 10-year life generates $50,000 of depreciation expense each year rather than being expensed in full at the time of purchase.

2. What distinguishes amortization from depreciation?

ℹ The definition explains that depreciation applies to tangible assets (machines, buildings) while amortization is the same concept applied to intangible assets (patents, customer lists, trademarks, software). The mechanics are identical - both allocate an asset's cost over its useful life.

3. According to the examples table, what is the annual straight-line depreciation on an office building costing $2,000,000 with a 40-year useful life?

ℹ $2,000,000 / 40 years = $50,000 per year. The table shows this is the same annual charge as the manufacturing machine ($500,000 / 10 years), illustrating how cost and useful life together determine the depreciation amount.

4. What does the pitfalls section warn about treating EBITDA as equivalent to free cash flow?

ℹ The pitfalls section states that D&A is a real economic cost even though it is non-cash - an asset that depreciates to zero must eventually be replaced, often at higher cost. Treating EBITDA as free cash flow ignores this CapEx requirement, especially in capital-intensive industries.

5. What accounting consequence does the FAQ identify from using accelerated depreciation for tax purposes?

ℹ The FAQ states that accelerated depreciation allows a company to deduct more in early years for tax than it records in its financial statements. This timing difference creates a deferred tax liability on the balance sheet.