Money in the bank for capital purchases
From time to time, I have clients ask me “What is funding depreciation?” And more importantly, they ask, “How can this technique make my organization more profitable and less stressful?”
Here’s a simple explanation.
It’s the setting aside of cash in amounts equal to an organization’s annual depreciation. The purpose: to fund future purchases of capital assets with cash.
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Funding Depreciation
Suppose you buy a $10,000 whiz-bang gizmo – a piece of equipment – that you expect to use for ten years, and at the end of the ten years you expect it to have no value. Your annual depreciation is $1,000.
In this example, a $1,000 depreciation expense is recognized annually on your income statement (depreciation decreases net income) even though no cash outlay occurs. The balance sheet includes the cost of the whiz-bang gizmo, but at the end of ten years, the equipment has a $0 book value, being fully depreciated.
The smart manager will annually set aside $1,000 in a safe investment – such as a certificate of deposit or money market account – for the future replacement of the whiz-bang gizmo.
If the company does not annually invest the $1,000, it has a few options at the end of the ten-year period:
- Borrow the full amount for the replacement cost
- Seek outside funding (e.g., grants)
- Use other funds from within the organization
- Ask U2 to do a special benefits concert – just kidding
Obviously, if you borrow money to replace the equipment, you will have to pay interest – another cash outlay. Suppose the rate is 10%. Now the organization must pay out $1,100 each year. If the organization funds the depreciation (invests $1,000 annually), it earns interest. If the entity chooses not to fund depreciation, it will pay interest.
Businesses that fund depreciation are always making money from interest (granted not much these days) rather than paying for it.
Another advantage to funding depreciation: you know you will have the money to purchase the capital asset. You’re not concerned with whether a creditor will lend you the money for the acquisition. You’re financially stronger.
Why Doesn’t Every Entity Fund Depreciation?
So why doesn’t everyone fund depreciation?
- Some don’t understand the concept
- Some had rather spend the cash flows for the ten years (e.g., owners taking too much in distributions)
- Some need the money just to run the organization
- In governments, elected officials desire to keep tax rates low while they are in office
- In growing businesses, the owners may need the money to fund the growth of the company
- Most importantly, it may require two cash payments (more in a moment)
Concerning the last point, if the business had to borrow money to purchase the initial capital asset, then it must make the debt service payments (cash outlay 1). If the company also funds depreciation for that same asset (making investments equal to the annual depreciation), another cash flow occurs (cash outlay 2).
If the business can ever get into a position where it pays cash for new equipment, it will be better off. Then only one cash outlay (investment funding) occurs, and the company is making–not paying–interest.
What if the organization cannot–due to cash flow constraints–fund depreciation for all new equipment purchases? Consider doing so for just one or two pieces of equipment–over time, the entity may be able to move into a fully funded position.
Who Should Fund Depreciation?
So, who should fund depreciation?
Organizations with sufficient cash flow and discipline. It’s the smart thing to do.
Imagine a world with no debt, a world where you don’t have to wonder how you will pay for equipment. Dreaming? Maybe, but it’s definitely worth consideration.
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