Depreciation & Amortization (D&A)
$$\text{Annual Depreciation} = \frac{\text{Asset Cost} - \text{Salvage Value}}{\text{Useful Life (years)}}$$
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
| 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
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.