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Depreciation Demystified: Understanding its Impact on Small Businesses

Depreciation is an accounting concept that is often misunderstood by small business owners. However, understanding depreciation is essential for any business owner who wants to maintain accurate financial records and make informed decisions about asset investments. In this article, we will explore what depreciation is, how it works, and its impact on small businesses.

What is Depreciation?

Depreciation is the term used to describe how quickly an asset loses value due to wear and tear, obsolescence, or other factors. When a business purchases an asset, such as equipment or machinery, it is recorded as an expense on the balance sheet. Over time, the value of the asset decreases, and the difference between the initial cost and the current value is the depreciation expense.

Depreciation can be calculated using several methods, including straight-line depreciation, declining balance depreciation, and sum-of-the-years'-digits depreciation. The method chosen depends on the type of asset and its expected useful life. 

How Does Depreciation Impact Small Businesses?

Depreciation has a significant impact on a small business's financial statements. When an asset is purchased, it is recorded as an expense on the balance sheet, which reduces the company's net income. However, this initial expense is not the only cost associated with the asset. The asset will continue to lose its value over time, which means that the company's expenses will increase, reducing net income further. 

Below are a few major ways in which Depreciation affects Small Businesses

Depreciation Does Not Affect Cash Flow 

Even though depreciation reduces net income, it does not affect cash flow. This is because depreciation is a non-cash expense that only reflects the reduction in the value of the asset. Therefore, a small business can use depreciation to reduce its taxable income without affecting its cash flow.

Depreciation Affects Taxable Income

Depreciation can also have a significant impact on a small business's taxes. The ATO allows businesses to deduct depreciation expenses from their taxable income, which can reduce the amount of taxes owed. This is known as a depreciation tax deduction, and it can be a significant benefit for small businesses that invest heavily in assets.

Depreciation Affects Debt-To-Equity Ratio

Another way that depreciation can impact a small business is through its effect on financial ratios. For example, depreciation reduces the value of assets on the balance sheet, which can increase the debt-to-equity ratio. This can make it more difficult for a small business to secure financing, as lenders may view the business as having a higher level of risk. 

Depreciation Affects Return On Investment

Depreciation also affects the calculation of return on assets (ROA), which is a measure of a company's profitability. A higher depreciation expense will reduce ROA, which can make the business appear less profitable. This can be problematic for small businesses that rely on profitability to attract investors or secure financing.

Depreciation is an essential concept for small business owners to understand, as it has a significant impact on financial statements, taxes, and financial ratios. While depreciation may seem complex, it is essential for accurate accounting and informed decision-making. Small business owners should consult with their accountant to ensure they are correctly accounting for depreciation and maximising its benefits.

Consider M.A.S. Partners for Your Small business Accounting Needs

Depreciation is complicated and is better handled by a professional accountant. To ensure that your business remains profitable despite depreciation, connect with our small business accountants in Sydney. To know more about us, click here.