Depreciation, and why it isn't cash

A new tractor lasts many years. It wouldn't make sense to count its whole cost in the year you bought it, so the accounts spread the cost over its working life. That spreading is called depreciation.

How it works

Say a machine costs $200,000 and is expected to last 10 years. One simple way is to count $20,000 a year as a cost, for 10 years. Accountants follow set methods and tax rules, so the figure in your accounts may be worked out differently. Check with your accountant how yours is calculated.

Depreciation applies to things that wear out, like machinery, vehicles, sheds, yards and fences. It doesn't usually apply to land.

Why it isn't cash

The money for the tractor left the bank when you paid for it. Or it leaves bit by bit, as you repay the loan you bought it with. Depreciation in later years is just the accounts recording the wear. No cheque goes out for it.

So when you work out cash, you add depreciation back to profit. That's why a farm can show a small profit and still have more cash than you'd expect.

Why it still matters

It's tempting to think depreciation doesn't count. It does. Machinery wears out and has to be replaced. If the money is spent on other things every year, there's nothing put aside when the tractor dies. Treat depreciation as a rough guide to what you need to reinvest each year just to stand still.

The mirror image: loan principal

Loan principal repayments work the other way. They're cash going out, but they aren't in the profit and loss. So to get from profit to cash:

1. Start with profit.
2. Add back depreciation, because it isn't cash.
3. Take off loan principal, because it is cash.
4. Take off drawings, and any spending on new machinery or land.

The repayment schedule splits each loan repayment into interest and principal, so you can see both parts. Our debt schedule template keeps all your loans on one page.

What to look for

Compare depreciation with what you actually spent on machinery and improvements over the last few years. If spending has been far below depreciation for a long time, your gear is getting older and a big bill is on its way. It's better to plan for it in the budget than to meet it in the overdraft.