Why you need to read between the lines of a company’s profits

Julie Brownlee, Fsp Invest, 16 May. 2014

Tags: company profits, profits, depreciation, what is depreciation, effect of depreciation on profits, investing,

You may think that looking at a company’s profits tells you everything you need to know about how well a company is doing. Unfortunately it’s not as easy as that. Profits only reflect the money a company has made on paper. It doesn’t mean the company has received the money. Not only that, depreciation can distort profits. So what is depreciation? And what effect does it have on a company’s profits? Let’s take a closer look…

The rather complex realm of company profits

Company profits don’t reflect the money physically coming into a company. If you want to check up on that, you need to look at the cash flow statement.

Different factors affect profits, Tim Bennett in Money Morning UK explains. This includes depreciation.

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Depreciation is an annual charge for using an asset in the business over its useful life. This could be a machine or some sort of plant equipment.

Let’s take a closer look at the effect of depreciation on profits with the help of an example…

A company has some plant equipment that cost it R500 million to buy. The company expect the plant equipment to last for ten years.

This means that a depreciation charge of R50 million (R500 million/10 years) a year comes off the profits.

So if a company’s profits for the year came in at R150 million, the effect of the depreciation charge would reduce that to R100 million.

But this doesn’t have anything to do with the money the company spent on the plant equipment. The company may have had to pay out the full R500 million in the first year and then no more for the following nine years.

Or the company may have borrowed the money from the bank.

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Companies can change depreciation charges to improve profits

Not only that, company directors can change depreciation figures to suit their own means. If they wanted to make profits appear higher, they could increase the number of years the equipment will last for.

For example, the company could state that the equipment will last for 20 years instead of ten. This would bring the yearly depreciation charge down to R25 million a year. Profits would then rise to R125 million.

So there you have it, why you need to read between the lines of a company’s profits.

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