Depreciation of tangible assets is really important for businesses and corporations, and in this screen-cast I'm going to talk all about depreciation. In the next screen-cast I will teach you how to use Excel. Excels got some built-in functions in order to solve for depreciation. First of all, what is depreciation and why is depreciation important? Depreciation accounts for normal wear and tear and the fact that tangible assets have a finite lifespan. So just as a simple example ,when you buy a car or maybe a bicycle, over time it depreciates in value. So you can't sell a used car or a used bike for the same amount that you purchase it for. So as time progresses and wear and tear happens to that asset, the value goes down and the amount that the value goes down is known as depreciation. Tangible assets are defined as items that have a physical form and hold value, so physical objects that you can purchase. So they have to be things that can depreciate in value. A business or company is allowed to write off annual depreciation of tangible assets when doing taxes, and what this does is it reduces the amount of taxes that a company has to pay. Depreciation is useful for accounting purposes, like when keeping track of assets in the financial statement of a company. It prepares the company also for replacement of equipment. So knowing that depreciation and how much an item has depreciated, you can prepare for replacement of large pieces of equipment. Again, most importantly, depreciation reduces taxes that must be paid by a company. Let's take a look at just this diagram here and if this confuses you or if you're a little bit uncertain, don't worry about it too much, but this is neglecting depreciation of assets. We've got this dotted line here. This dotted line represents basically anything, any cash flow that comes into or out of a company. We've got revenue, so this is sales, denoted by S, and there's always a cost of sales, how much money you have to spend on your product, so that's known as a cost of sales. The difference between sales and cost of sales is known as profit, so this is how much the company is able to keep from the revenue. The profit though is split into two categories. We have taxes, a company has to pay taxes. This is a Greek letter phi, so that's just like a symbol and some people just call that t for tax I just have it phi. But essentially, a tax rate might be something like 30% or greater if you're a larger corporation. But we take our tax rate and we multiply by the profit and the profit is just sales minus cost of sales. So that's the amount of the profit that the company has to pay in taxes. The remaining, so one minus the tax rate times the profit, or sales minus cost of sales, is known as the after-tax earnings, and this is also known as the cash flow. So this is essentially the amount of money that is kept internally by the company. So this neglects depreciation of assets. The government will allow you to depreciate capital euipment costs and essentially the difference between this slide and the previous is that we have this depreciation arrow. Depreciation is the amount of all of your capital equipment that is depreciating in that calendar year, or whatever period you are performing taxes for. So the profit is no longer sales minus cost of sales or revenue minus cost of sales, we decrease the profit by the amount of depreciation, so we have sales minus cost of sales minus depreciation. And so that goes directly into the cash flow for a company. The taxes then orthe tax rate, again, we have our tax rate phi and that's just a fraction, like 30% or 40% or somewhere in between. And that's multiplied not by sales minus cost of sales as we had before, but now we're reducing by our depreciation. And so depreciation is going to lower the taxes that a company has to pay. The after tax earnings, this arrow here, is just the difference between the taxes and the profit. So this is one minus the tax rate times sales minus cost of sales minus depreciation. We have reduced the after tax earnings a little bit because now we have eliminated depreciation. Our after tax earnings is a little bit less, but we are including depreciation in the cash flow and so the cash flow is actually more. We have our after tax earnings plus depreciation. In the end this is a little bit more cash flow or what's kept internally by a company than if we exclude depreciation of assets. So I've got a little example here. Again, we have our equations here for neglecting depreciation. If you're having a hard time understanding this, I wouldn't worry about it too much. This is just more out here for your benefit, but we have our equations here. Let's work through an example without depreciation. Let's just say a company that our revenue or sales is 150,000. The cost of sales is 50,000, so that's amount of money that we spend on everything that's required to get our product developed and produced, maybe advertised. We have a tax rate of 30%, 0.30, and so the taxes that we pay is 30% of our profit. Our profit is 150,000- 50,000. When we do that calculation we end up paying $30,000 in taxes. Now, the cash flow in this case is just the after tax earnings and that's just whatever's left of our profit. And so we do 1- the tax rate, or 70% times the $100,000 that we get for profit and that gives us $70,000. Now, let's take a look at what if we include depreciation? We have our equations up here, they're a little bit different because they include depreciation. Our taxes are going to be a little bit less, our after tax earnings by itself are going to be a little bit less, but our cash flow is going to be a little bit more because we're adding back depreciation. So let's go through the same example. We have the same cost of sales. We have the same sales or revenue. Our depreciation, let's just say we have something like $20,000. That might be a little bit too much, but I'm just going to use it for this example to demonstrate what happens if we depreciate. Our tax rate is the same, so the taxes, the amount of taxes that we pay, is going to be our tax rate multiplied by 150,000, that's our sales, minus the cost of sales. We also include or subtract depreciation. In the end we're paying $24,000 in taxes as opposed to $30,000 in taxes that we paid excluding depreciation. The cash flow, we can use our equations up here, we do 1 minus our tax rate times the profit. Profit, again, we remove depreciation, but we're adding back depreciation at the end in our financial statement. And what that really means is the cash flow, the money that's kept internally in the company, instead of 70,000 that we had neglecting depreciation, we have a little bit more, we have 76,000. If we take a look at this graphically, and the next screen-cast is going to show you the different types of depreciation. This is just straight line depreciation. We have the value on the y-axis as a function of time. Here we're going up to a useful life of 5 years. Assets, generally, they're defined by a useful life. In this case we have a salvage value, that's the amount that you can sell the equipment for, that whatever it is, at the end of its useful life. And we have our purchase cost. So the amount that the value is decreasing each year is known as the annual depreciation. In straight line depreciation it's just a straight line. And each year the asset is going to depreciate we take our purchase costs, we subtract the salvage value, that's $8,000, we divided by the useful life. And when we do that calculation, we get a depreciation of this assets of $1,600 per year. And so that's just an example of how we can calculate depreciation. And then this $1,600 per year, we add that up to other assets we might have, and that's going into the cash flow and the financial statements of that company or business. So in summary, if you don't understand depreciation cash flow after tax earnings, it's okay, the important thing that you're going to learn in this course is how to use Excel functions. And a lot of you I know you work in financial areas and so knowing how to use Excel formulas for depreciation is really important. In the next screen-cast we're going to explore the various depreciation methods and how to implement those different depreciation methods into Excel using Excel functions.
