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  • Average Rate of Return: Definition, Formula and Calculation

    Average Rate of Return: Definition, Formula and Calculation

    Introduction

    It is always pertinent to understand the expected average returns from the investment you are going to make. It helps you analyze the risk and opportunities involved in the investment, and whether the risk justifies the returns you will get. In order to do so, investors calculate the Average rate of Return, also called the Accounting Rate of Return, to analyze if the investment is worth it or not. 

    This guide will help you understand the average rate of Return and how you can calculate it with the help of relevant examples. 

    What does the Average rate of Return mean?

    The average rate of Return means the average amount of return an investor expects on his initial investment at the end of the investment period. It is calculated by first determining the average annual returns on the investment after deducting taxes and dividing it by the initial investment. 

    The expected returns can be annual, monthly, or quarterly, depending upon the nature of the investment. The value is then represented in percentage terms. 

    Now let’s check out how to calculate the average rate of Return along with the help of the formula.

    Formula

    The average rate of Return is mathematically represented as-.

    Average rate of return= Average Annual net Returns after taxes / Initial Investment * 100

    To find the average annual returns, you will have to apply the below formula:

    Average Annual Return= Sum of all the Annual Returns / No. of years investment is expected to last

    Calculation

    Now let’s check out the following step-by-step process to calculate the average rate of Return.

    1. First, find out the annual earnings, i.e., profits earned from the investment. You can do so by subtracting the investment cost, including depreciation (in case of fixed investments) from the total earnings received from that investment. So if the investment is made for 5 years, then find out the annual earnings for each year.
    2. Now you need to find out the annual average returns from the investment. To do so, add the annual profits for all the years and divide it by the number of years the investment is made. 
    3. For one time investment, find the initial investment, and for regular investment, calculate the average investment over the period of time. 
    4. Lastly, divide the annual average returns by the initial investment and multiply it by 100% in the case of a one-time investment. For regular investment, divide the annual average returns by the average investment and multiply it by 100% to find out the average rate of Return. 

    Example

    Now let’s understand the concept further by taking an example of an Indian Corporate house Tata Power. They have made a fixed investment on Power projects for 3 years. The investment is expected to give returns of 50 Lakhs in the first year, 60 lakhs in the second year, and 70 Lakhs in the third year (all monetary value in rupees). 

    The initial investment made by Tata Power is 5 crores, and the investment life is 3 years. 

    With this, the first step to calculating the average rate of returns is finding out the average annual returns.

    Annual Average returns= Sum of Profits of Year 1, Year 2 and Year 3/ Investment period

                                              = 50L + 60L + 70L / 3 (years)

                                              = 60 Lakhs

    Now for calculating the average rate of Return for Tata Power, follow the formula below.

    Average Rate of Return = Annual Average Returns / Initial Investment 

                                               = 60L / 5 crores * 100%

                                               = 12%

    Therefore the average rate of Return of the investment made by Tata Power is 12%.

     

    Limitations

    The concept also has its flaws and limitations, which investors should keep in mind before making any investment decision based on the average rate of Return. Following are the limitations of the concept:

    1. One of the primary limitations of the average rate of Return is that it doesn’t take into account the time value of money. It simply means that inflation decreases the purchasing power of money in later years. Therefore, the profits you get in the future will have less value than the profits received today. Simply saying, the average rate of Return does not consider inflation. This can have a severe effect on your investment.
    2. The average rate of Return only includes the accounting information and is not based on the actual cash flow.
    3. Moreover, the average rate of Return also has consistency issues as different financial analysts can calculate it in different ways.
    4. Lastly, if two investments give the same returns, investors cannot differentiate both on the basis of the amount of money required. 

    Conclusion

    With all its flaws and limitations, the average rate of Return is still a simple and quick way to check out the cost-benefit analysis of any investment in the initial planning period. The investors also use this metric to rank the assets, decide the investment plan per the ranking and include them in the portfolio.

    Moreover, the data used for calculating the same can be easily interpreted and accessed. Although it does not factor in the time value of the investment, it provides a brief outlook of the worthiness of the investment. 

    References

  • Average Selling Price (ASP)

    Average Selling Price (ASP)

    Have you ever wondered what is Average Selling Price and why manufacturers leverage it? The average selling price (ASP) varies depending on the market and is frequently used in the retail and technology sectors. It’s an indicative metric that denotes the average price at which specific products are sold across market vertical. This blog will walk you through the concept of ASP and its applications. 

    What Is Average Selling Price (ASP)?

    The price at which a particular type of product or service is frequently sold is referred to as the average selling price (ASP). It means the price at which a product typically sells across various distribution channels, a company’s product line, or even the whole market. 

    An established average selling price (ASP) for a specific good can serve as a benchmark price to assist other manufacturers, producers, or merchants in determining their products’ prices. When trying to choose a price for a product, marketers must also think about how they want their product to be positioned. They must set a higher ASP if they want their product to emerge in a high-quality category.

    While items like books and DVDs have a low average selling price, items like computers, cameras, televisions, and jewelry normally have higher average selling prices. The type of product and the stage of the product life cycle has an impact on the average selling price. The market is most likely saturated with competitors when a product is towards the end of its life cycle, which lowers the ASP.

    In the housing sector, the ASP has a significant implication. A thriving market may be indicated when the ASP of a house in a given area increases. On the other hand, when the average price decreases, the perception of that area’s market also declines.

    How To Calculate The AVP?

    Divide the entire revenue from the product or service by the total number of units sold to obtain at the ASP. Given the laws against fraudulent reporting, this average selling price is typically published during quarterly financial results.

    Consider an example of a hotel room. The hospitality industry refers to the ASP as the average room or daily rate. When travel appears to be slow such as in off-seasons, the average daily rate of the room tends to be lower, whereas, during peak seasons, the rates are higher.

    To measure the ASP of the hotel room, take the total amount of room bookings and divide it by the number of bookings closed. For example, if you have earned ₹45,000 of revenue and closed 12 bookings, your ASP would be ₹45,000 / 12 = ₹3,750.

    What Are The Applications Of The AVP?

    Market Entry

    The average selling price can be used by businesses entering a new market to help them decide how to position themselves. Imagine that a business wants to start producing men’s shirts.

    They see that the ASP for shirts is ₹600 when they look at the market. The company might choose to price its product at ₹1,000 to establish itself as a high-end merchant. They might enter with pricing that is in line with the market or set the price at ₹450 to be a bargain shop. 

    If you enter at a lower selling price, your profit margins can be constrained. Entering the market at a premium price may result in higher margins but lower sales.

    Decision-Making And Trends

    The average selling price can be used by businesses currently in the market for a certain good or service to spot trends and make choices. An indication that the market for a particular service is declining might be seen if a company notices that the average selling price of that service is declining over time. The company must leave the market since the demand is decreasing.

    Whether the ASP is rising or falling is not always a good thing or a bad thing. For instance, a company might sell power banks for ₹1000 each and sell 1,00,000 units in the first year. That represents revenue of ₹10,00,00,000. The next year, they reduced their average selling price per unit to ₹800.

    Although a 20% decline may seem alarming, the company ultimately sold 1,80,000 units in the second year for a total of ₹14,40,00,000 in sales. Even though the selling price dropped, the revenue rose by approximately 45%.

    Businesses are willing to make a trade-off by lowering prices to increase sales volume. It also functions in the other direction. A rising ASP may eventually result in each price rise, causing a decrease in sales volume, making it risky to continue raising prices.

    Draw Conclusions

    The investment community will examine the average selling price to draw judgments about a good or service, a company, or a market. Consider a camera company as an example. DSLR cameras are essentially the focus of the camera company’s business.

    The investment community will keep an eye on the average selling price of a company when it is based mostly on one product. A price decrease may indicate increased competition, diminished negotiating power with clients, or a decline in demand, all of which can indicate failure.

    As previously stated, if an increase in sales volume accompanies a decrease in the average selling price, it is not necessarily bad. It would be problematic if the ASP of the company’s DSLR cameras decreased without an increase in the number of units sold.

    Final Words

    The phrase “average selling price” (ASP) refers to the typical price at which a good or service is sold. Simply dividing the entire income received by the total number of units sold yields the ASP. Analysts, investors, prospective businesses, current businesses, and other businesses can use the average selling price as a benchmark and conduct an analysis on it.

    FAQs

    Why is ASP important?

    The average selling price can be used as a benchmark and analyzed for business and investment decisions by existing firms, new enterprises, analysts, and investors.

    What is ASP growth?

    A change in ASP impacts revenues, profits, and eventually the stock prices of a business. An ASP growth implies a rising average selling price, a positive performance indicator.

  • Book Profit: definition, example, how to calculate book profit

    Book Profit: definition, example, how to calculate book profit

    Introduction

    In accounting, Book Profit is a frequently used term, and it is essential to understand the meaning of Book Profit to excel at accounting. It tends to put up the profits earned by a company using a straightforward formula, which is a significant step in accounting.

    This article highlights the concept of book profit and explains the procedure to compute the same.

    Defining Book profit

    It is evident that profit is the sum of the Market Price removed from the Sale Price. The term “book profit” describes a profit that has been recorded in the business’s accounting records but has not yet been realized. 

    Since the profit is still recorded in the company’s books of accounts, it is known as Book Profit. When the company realizes the earnings, it becomes realized profits and is included in net profits.

    Calculating book profit is crucial for figuring out the business’s tax obligations. According to the Income Tax Act and share market jargon, book profit is defined differently. 

    In simple terms, book profit can also be defined as what you get as a result when you deduct all expenses from a business’s revenue. Therefore, it is the financial income of any company before taking the taxes into account. 

    Explaining Book Profit?

    Most of the book profit calculation is influenced by GAAP (Generally Accepted Accounting Principles). It indicates that the accrual method of accounting is used. Cash receipts and payments are not taken into account while recording revenue or expenses.

    Instead, income is reported as it is earned and costs as they are incurred. Thus, monetary sales are not the only source of revenue. Similarly, expenses are not limited to ones paid in cash. When correctly accounted for, book profit is a good indicator of a company’s profitability. 

    In general, the business benefits more from more significant book profits. It evaluates a company’s financial performance over a specific time frame. Since it is determined using accepted accounting principles, book profit can be used to compare a company to others. It also complies with the requirements of certain government agencies. By complying with the GAAP, book profit provides an organization’s stakeholders with clear information about its profitability.

    Understanding Book Profit and Taxable Income

    A company’s taxable profit might not necessarily match book profit (or taxable income). This is because the two have conflicting interpretations of particular revenue and spending elements.

    For instance, the only permitted method of depreciation for taxation purposes is MACRS (Modified Accelerated Cost Recovery System). If the company uses a depreciation method different from MACRS for financial accounting, this leads to a difference in the depreciation amount.

    Additionally, some expenses are not tax-deductible for income-related reasons. For instance, entertainment and representation costs are not tax deductible. Typically, book profit does not match taxable profit due to the variations in interpretation.

    So, accountants make specific reconciling entries to transform book profit into taxable profit. The basis for calculating a business’s income tax obligation is its taxable earnings.

    On a company’s tax return, you will notice the net profit or income amount. The tax code serves as the foundation for calculating both income tax and taxable profit.

    Any modifications to GAAP have no impact on taxable earnings because it is determined by a different standard (IRS regulations). Instead, it is impacted by any changes to tax legislation. As a result, even if a company consistently performs at a high level throughout time, changes in tax laws may cause its taxable income to alter. Therefore, an expense previously non-deductible, for instance, might now be deductible

    How to calculate Book Profit?

    It is easy to learn the calculation of Book Profit once we understand it comprehensively. The formula for calculating the book profit is:

                                                       Book Profit= Revenue- Expenses

    It is easier to understand through examples, so here is one which shows the calculation of the Book Profit:

    John and Sons Company has the following mentioned revenue and expense figures (in Rupees)-
    Total cash sales
    350000
    Total credit sales
    700000
    Total cost of sales
    660700
    Total operating expenses
    275550
    Other income
    184200
    Other expenses
    66308

    Now, with these figures, we can easily calculate the book profit for John and Sons Company. The same formula mentioned above shall be used to calculate book profit. So, in order to calculate the final revenue figure, we need to add the total cash sales, credit sales, and other income. 

                                      REVENUE- 350000+700000+184200=1234200

    Also, to find the final expenses figure, we need to add the total cost of sales, operating expenses, and other expenses.

                                      EXPENSES= 660700+275550+66308= 1002558

    Finally, book profit will equal to REVENUE- EXPENSES, which is 1234200-1002558=231642    

    Book Profit and Net Profit

    As both of these terms are so commonly used in accounting terminology, it is crucial to understand them properly.

    • Book profit means the profit calculated in accordance with the applicable provisions of the Income Tax Act. 
    • Whereas, Net profit is the profit calculated in line with the company’s Book of Accounts and the applicable provisions of the Companies Act.
    • In the event of business formation, book profit is not taken into account when calculating tax. Meanwhile, net profit is calculated after accounting for the corporation’s tax liability.
    • Analysts and stakeholders do not monitor it; instead, it is used chiefly for taxation. Net profit is a crucial metric used for many financial ratios and is actively watched by analysts and stakeholders.

    Conclusion

    The calculation of the tax liability for every organization requires the determination of book profit. That is the reason it holds importance in accounting. Book Profit also brings with it the understanding of taxes and net profit, thus helping you make better action plans for your business. 

    References

    https://fundsnetservices.com/book-profit

    https://www.wallstreetmojo.com/book-profit/

    https://www.educba.com/book-profit/
  • What is the Present Value in Excel?

    What is the Present Value in Excel?

    A financial function, Present Value, calculates the present value of a loan or investment based on a fixed interest rate. PV can be used either with regular and constant payments (such as mortgages or other loans) or for future value, an investment objective. Balance sheet analysis uses PV to calculate the dollar value of current and future payments. For multiple payments, we assume periodic fixed payments and fixed interest rates. Alternatively, you can use this function to calculate the present value of a single future value.

    As part of the time value principle, present value is one of the most important concepts in the financial world. It helps you compare different investment options and choose the most profitable option. The PV feature can be used for both recurring deposits and withdrawals or one-time deposits and withdrawals.  

    All You Need to Know about Present Value in Excel

    • The PV function is an Excel financial function used to calculate the present value of future payments/receipts based on a constant interest rate.
    • The current value can be calculated without using the PV function but using the PV function greatly improves efficiency.
    • Present value is an important concept in the financial world based on the time value principle.
    • One use of present value is to select the most profitable investment from a range of alternatives.
    • It is important to match the units used to express the rate and number of periods (NPER).
    • #VALUE! error – This happens if any of the specified arguments are non-numeric.

    How to calculate the Present Value

    Syntax

    The PV function uses the following arguments:

    • Rate (compulsory argument) – Interest rate for each compounding period. A loan with 14% annual interest payable monthly will have a monthly interest rate of 14%/12 or 1%. Therefore, the rate will be 1%.
    • nper (compulsory argument) – Number of payment periods. For example, a 2-year loan with monthly payments will have 24 installments. Therefore, nper will be 24 months.
    • pmt (compulsory argument) – Fixed payment per period. 
    • Fv (optional argument) – The future value of the investment at the end of all payment periods (each). There is no entry for the FV, and Excel automatically assumes the entry is 0.
    • Type (non-compulsory argument) – Type indicates when payments are issued. Only two entries are present, i.e., 0 and 1. If the type is missing or the entry is 0, payments will be paid at the end of the period. If set to 1, payments will be made at the beginning of the period.

    Examples of PV formulas in Excel

    Assuming he has $50,000 in his bank account at 5% interest in 10 years, you can calculate how much you need to invest today to get there.

    You can label cell A1 “Year” in Excel. Also, enter the number of years (10 in this case) in cell B1. Label cell A2 as Interest Rate and enter 5% (0.05) in cell B2. Enter the name Future Value in cell A3 and $50,000 in cell B3. The built-in function PV can easily compute the current value given the information. In cell A4 enter “current value” and in B4 enter the PV formula =PV (rate, nper, pmt, [fv], [type], in this example “=PV (B2,B1 , 0,B3)” To do. )

    There is no intervening payment, so 0 is used for the “PMT” argument. The cash value is calculated as ($30,695.66). Because this is the amount you need to deposit into your account, this is considered a cash outflow and is therefore displayed as a negative number. Excel displays current values ​​as inflows when future values ​​are displayed as outflows.

    What is Net Present Value?

    The total present value of a series of payments and future cash flows is known as the net present value. A tool for comparing goods with cash flows that are dispersed over the years is provided by NPV. Numerous other uses, such as loans, payouts, and investments, can use this idea. 

    The net present value is the difference between today’s projected cash flows and today’s cash investment value. It is a crucial notion in capital budgeting as well. It is an intricate and thorough method of determining whether a project is financially viable. If the current value is positive, the business earns a profit since its sales exceed its costs. This is also mainly used by companies in order to determine the potential profits in a project which is vital for capital budgeting. 

    Generally, a project or investment with a high NPV is more appealing than one with a low or negative NPV. However, consider that before giving something the all-clear, businesses often consider other data. In case a huge capital is required to fund the project, the NPV will be much lower. In most cases, the project or investment with the highest net present value (NPV) is pursued.

    Key differences between Present Value & Net Present Value

    • The sum of all future cash inflows delivered at a specific rate is called present value, or PV. Contrarily, the Net Present Value (NPV) is the difference between the cash flows generated over time and the initial investment needed to fund the transaction.
    • Making investment decisions for vehicles or determining the worth of liabilities, as well as decisions regarding bonds and spot rates, are all made easier with the help of present value. On the other hand, NPV is mainly used by companies to evaluate investment planning decisions. It is important to assume that any project with a positive present value is profitable.
    • The present value calculation simply discounts the future cash flows at the desired rate of return for the desired period. However, NPV is more complex and considers cash flows over different time periods.
    • Net present value is useful in calculating profits, but the present value is not useful in calculating wealth or profitability.
    • Net present value considers the initial investment required to calculate the net amount, whereas present value only considers cash flows.
    • Understanding the concept of present value is very important. However, the concept of NPV is broader and more complex.
  • The Ultimate Cash Flow Guide – Understand CF, FCF, FCFF, FCFE

    The Ultimate Cash Flow Guide – Understand CF, FCF, FCFF, FCFE

    or

    Cash Flow Guide for Beginners – Understand CF, FCF, FCFF, FCFE

     

    “Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.”

    —Peter Drucker

    Cash flow is one of the most decisive metrics in the valuation of companies, especially in industries where cash flow is hard to predict or isn’t always positive. In an organization, cash flow is typically a means of evaluating cash available for reinvestments and overall company liquidity. 

    There are several terms associated with a cash flow that all denote different meanings. So in this guide, we’ll understand the cash flow statement, free cash flow, free cash flow to equity, and free cash flow to the firm. 

    Cash Flow (CF):

    Cash flow means the net inflow and outflow of cash and cash equivalents at the year-end, where cash received is represented as inflow and cash paid as outflow. Cash flow statements are divided into three parts-

    Cash flow from operating activities such as sales of finished goods,

    Cash flow from investing activities, such as dividends received on investment in other companies, 

    Cash flow from financing activities, such as the issue of fresh equity. 

    Positive cash flow means that a company’s liquid assets are growing. It means that it can repay its liabilities, invest in its business, return money to shareholders, pay expenses, and protect itself from future financial problems. Companies with favourable cash flow can take advantage of profitable investments. They also perform better during economic downturns to avoid the consequences of financial distress.

    The cash flow statement is a mandatory financial statement released by a company. The cash flow statement is a formal financial statement that shows a company’s sources and usages of cash over a financial year. The stakeholders use cash flow statements to take their financial decisions on whether to invest in such a company. 

    Cash also includes cash equivalents such as liquid assets, marketable securities, and assets that can be liquified in a very short term. 

    Free Cash Flow (FCF)

    Free cash flow means the cash available for an entity to repay to its creditors, interest to the debt holders, and dividends to the shareholders. It represents the profits after excluding non-cash expenses on the profit-and-loss statement and includes expenses on assets and changes in working capital.

    Evaluating free cash flow and understanding helps the firm manage its cash better. It helps in understanding trends of the company’s financial position and operating cycle. 

    Free cash flow is a significant number because it shows its financials. Investors use free cash flow to figure out if a company has enough money to pay out dividends or buy back its shares.

    Learning about the company’s finances through the FCF calculation can help investors make sound investment decisions.

     Here’s the formula:

     FCF = Cash from operations – capital expenditures (CapEx)

    Let’s understand with an example-

    Particulars
    Amount
    revenue
    12,00,000
    Cost of revenue
    10,000,00
    Operating expenses
    2,00,000
    Selling expenses
    50,000
    Interest paid
    10,000
    Income tax
    15,000
    Net operating income
    1,25,000

    Here are the other details:

    1. Depreciation – 5,000
    2. Current assets – 12,000
    3. Current liabilities – 7,000
    4. Fixed assets – 2,00,000
    5. Tax rate is 30%

    Calculate- FCF

    FCF = Cash from operations – capital expenditures (CapEx)

    FCF = 1,25,000 – [(12,000-7,000) + (5,000+2,00,000)]

    FCF = -85,000

    To determine the company’s expected performance, investors need to use other variations of free cash flow, as interest payments are excluded from the definition of free cash flow. 

    There are two variations available that have already been adjusted for interest payments and borrowings:

    •  Free cash flow to the firm
    •  Free cash flow of the equity

    Free Cash Flow to Firm (FCFF)

    FCFF is a measure of a company’s ability to pay dividends or interests, buy back shares, or repay debt. Any person who wants to invest in a company’s corporate bond or stocks should look at its FCFF. 

    After the company pays all its operating costs and investments in working capital and long-term assets, the cash left is called “FCFF,” or “Free Cash Flow”. FCFF is the money available for its bondholders and stockholders.

    The FCFF formula is a measurement of a company’s operations and performance. FCFF looks at all cash inflow, all-cash outflow, and all cash reinvestments in the business to grow. Cash available after above mentions deductions is known as a free cash flow to the firm. 

    Free Cash Flow to Firm (FCFF) is also a critical indicator of a company’s stock value. When people talk about the value or price of a stock, we determine its expected future cash flows. Investors can evaluate the fair price of the company’s stock by FCFF. 

    • A positive FCFF value means that the company has the cash left for its shareholders and bondholders. 
    • Negative FCFF values show that the company does not have cash for distribution. 

    The formula for determining Free Cash Flow to the firm:

    FCFF= Net Income + Depreciation and amortization + Interest (1-tax rate) – working capital investments – capital expenditure

    Let’s understand by referring to the same example as above- 

    = 1,25,000 + 5,000 + 10,000(1-.30) – (12,000-7,000) – (5,000+2,00,000)

    = -73,000

    Free Cash Flow to Equity (FCFE)

    Free cash flow to equity measures how much money is available to a company’s equity shareholders after excluding operating expenses, debt repayments, interest payments, and reinvestments. 

    There are four parts to free cash flow to equity: 

    • Net Income, 
    • Capital Expenditures, 
    • Working Capital, and 
    • Debt.

    How to find out four elements of FCFE

    Net Income

    Net income can be taken over from the income statement of the relevant financial year. 

    Capital expenditures

    Capital expenditure can be determined by cash flow from investing activities of the cash flow statements. 

    Working capital

    The company’s working capital can be determined by changes in working capital statements or cash flow from operating activities of the cash flow statements. The basic formula for determining working capital is:

    Working Capital = Current Assets – Current Liabilities

    Debt

    The balance sheet of the company shows the total amount of the debt. 

    Cash available for the shareholder is not equal to cash paid to the shareholders.

    Analysts use the FCFE number to evaluate a company’s net worth. FCFE may figure out how much money is available to shareholders, but that doesn’t always mean how much they paid out to shareholders. Only a part of distributable profits is paid as dividends. Companies reinvest the rest of the amount in the business for expansion. 

    The formula of calculating Free Cash Flow to the equity-

    FCFE = Cash from operations − CapEx + Net debt issued

    Let’s understand by referring to the above example:

    Assuming net debt issued of the company is 1,50,000 and all other information is same, FCFE is-

    = 1,25,000 – [(12,000-7,000) + (5,000+2,00,000)] + 1,50,000

    = 65,000

    Conclusion:

    By analyzing the above-detailed discussions over various diversified ways of measurement, we conclude that cash flow is a part of current assets and an essential dimension to judge a company’s financial position. Cash flow formulae are a helpful tool for making financial decisions for investors and management.

  • What is depreciation and how is it calculated?

    What is depreciation and how is it calculated?

    What is depreciation and how is it calculated?

    Every material thing wears off after a certain period. The value doesn’t stay the same with time, whether it is a car or a piece of heavy machinery. The application of depreciation causes a decrease in this value. Depreciation helps in finding the fair value of an item to be added to the balance sheet of a company. This article will look into the meaning of depreciation, cause of deprecation, types of depreciation, and how it is different from amortization. 

    What is depreciation?

    Depreciation is applied to all the physical or tangible long-term assets bought for the business over its useful life. The useful value of an asset is calculated based on the time frame it can be used. For example, machinery is typically useful for 10-15 years. 

    Each year, a certain percentage or amount is written down from the acquisition cost of an asset. In simple terms, depreciation means deducting the value of an asset that has already been used. A company must account for depreciation on assets at least annually. 

    Example of depreciation

    Suppose the total value of a machine is Rs. 9,00,000. If the depreciation rate is 10%, annually Rs. 90,000 will be deducted from its useful life.

    The depreciation cost is applied to an asset until the value becomes zero. Based on the types of assets, different depreciation methods are used. It is crucial to note that depreciation holds value from accounting as well as taxation purposes. 

    What is the cause of depreciation?

    With time, the quality and usefulness of an asset reduce, and it becomes less valuable and less productive. It is necessary to mention this amount as a depreciation cost in the balance sheet to showcase the value lost over a certain period. That is the leading cause we apply depreciation to assets. However, it is a non-cash expense and thus has no impact on the cash flow statement. 

    What are the types of depreciation?

    Before understanding types of depreciation, a basic understanding of these terms is a must.

    • Salvage value of an asset: The amount at which a company is ready to sell its assets–the reduced price, is known as the salvage value.
    • Useful life: It is the period till which an asset is considered appropriate to use and is cost-effective.
    • The cost of an asset: It is the additional cost that a company pays to acquire an asset, such as shipping, taxes, etc.

    Now let’s see how depreciation is calculated using these four methods.

    1. Straight-Line method

    This is one of the simplest and most popular types of depreciation. As per the straight-line method, the same amount is dedicated as depreciation from the asset’s total cost each year.  

    The depreciation formula for this method is:

    Depreciation = Total Cost – Salvage Value of Asset / Useful Life of Asset

    2. Double Declining Balance method

    This method is used to write down a significant sum of depreciation in the initial years compared to the last few years of the life cycle of an asset. The reason to depreciate an asset using this method is the fact that in the initial years, when an asset is new, it is the most predictive and cost-efficient. Also, the most value lost occurs in the first few years of buying an asset. For using the double-declining balance method, the depreciation percentage is considered 2X compared to the straight-line method. 

    The depreciation formula for this method is:

    Depreciation = Initial Book Value of an Asset X Depreciation Rate

    3. Unit of Production method

    This is a method that calculates depreciation based on the production output. It considers the total expected output units or the hours invested for production over the useful life of an asset. A specific rate is allotted to each production unit in this method. The unit of production depreciation method is used chiefly at larger assembly or production facilities. 

    The depreciation formula for this method is:

    Depreciation = Total Number of Units Produced / Useful Life in Number of Units X (Total Cost – Salvage Value of Asset) 

    4. Sum of the Years Digits method

    Like the double-declining method, the sum of the years digit also expenses depreciation at a higher pace in the initial years compared to the letter years. It continues until the asset value becomes zero. 

    The depreciation formula for this method is:

    Depreciation = Remaining Life of Asset / Sum of the Years Digits X (Total Cost – Salvage Value of Asset)

    What is the difference between depreciation and amortization?

    The term depreciation and amortization appears confusing, and they are indeed similar in nature but what sets them apart is the type of asset they are used for. While depreciation reduces the cost of usage over the useful life of a tangible asset, amortization reduces the cost of usage over the useful life of an intangible asset. Intangible assets are the types of assets that hold value to a business but cannot be seen or touched. 

    Depreciation is used for assets such as plants, machinery, building, furniture, vehicles, etc. While amortization is used for trademarks, patents, copyrights, etc. 

    While depreciation is calculated using different methods, amortization uses the straight-line method. It ensures a steady reduction in the value each year. 

    The bottom line

    Depreciation reduces the cost of an asset from the total benefits received from it over its useful life, such as increased earning. A company has to account for depreciation on assets using any written down value method at the end of the year and on its quarterly report submissions as well. It is a fixed cost for a company as depreciation is deducted each year whether the company makes a profit. Though depreciation also provides tax benefits, it reduces the earnings and thus saves costs. 

  • The Ultimate Guide To Accrual Accounting

    The Ultimate Guide To Accrual Accounting

    Transactions when recorded as they happen and not when the actual payment has been made follow the accrual basis of accounting. This blog outlines what it is and how it works.

    Walter Harvey Pvt Ltd, a cloth manufacturing company, sold 1000 men’s shirts on credit to a clothing store and generated an invoice on March 10, 2022. The company will receive the order payment on March 22, 2022. Still, it recorded its sales on the date it generated the invoice.

    Walter Harvey received raw material for an upcoming order on March 12, 2022. On the same lines, it recorded that expense on the date it received the order, i.e., March 12, 2022, although it paid the supplier on March 16, 2022. 

    However, when it paid rent from April to June 2022, in advance, i.e., on March 31, 2022, it didn’t recognize it as rent expenses in March. This is because those rent expenses belonged to April to June 2022 but were paid on March 31, 2022. Likewise, Walter Harvey makes provisions for utility expenses accordingly at the end of every month. However, it makes the actual payment in the subsequent month.

    Walter Harvey records its income tax expenses as per the revenue generated in the financial year, regardless of the actual payment. 

    Here, it is evident that Walter Harvey books its expenses and revenue in the period for which they are related and not in the actual cash inflow or outflow period. This suggests that Walter Harvey Pvt Ltd follows the accrual principle in accounting.

    Every company follows certain rules or methods to report its revenues and expenses. Such a set of rules is called an accounting method. Primarily, there are two types of accounting methods – accrual accounting and cash accounting. The main difference between the two accounting methods relates to the time when revenue and expenses are recognized. 

    Here you’ll be guided about what accrual accounting exactly is, how it works and what are its benefits and limitations.

    What does it actually mean?

    Accrual accounting is a method for financial accounting that enables a company to report revenue earned even before receiving payment for goods or services sold or to report expenses as incurred before the company has actually paid for them in the books of account. The accrual principle aims to report revenues and expenses within the same period, which is known as the matching principle. 

    To put it another way, the revenues earned and expenses incurred are reported in the company’s books of account, not considering when cash flow has happened. The other financial accounting method, though, cash accounting, reports the revenues earned and expenses incurred when the cash transactions have taken place in reality.

    What is “accrual” in accounting?

    The word “accrual” in accounting refers to the revenue earned or expense incurred that impacts the company’s net income on the income statement. Still, the cash inflow and cash outflow related to the revenue or expense have not yet occurred. 

    How does it work?

    In a company that follows the accrual concept in accounting, the accountant reports the revenue from a sales order and the related expenses. As both amounts are reported in the same period, the company’s financial statements give a precise interpretation of its profitability. 

    This means the accountant reports the revenue once the revenue can be recognized (most probably, once the products have been shipped or services have been given). Therefore, the accountant creates an invoice from the sales order (having each product’s name, quantity, and amount to be paid). Also, the accountant reports the cost of products sent, which comes from the database of inventory costs. Now, as the sale has been reported already, the cash receipt from a customer will not affect the sales figure. Rather, it shows a reduction in accounts receivable.

    Example of accrual accounting

    Assume that you own an art supply store. You sell art supplies to professional artists, art students, art hobbyists, and art colleges. One of your most loyal customers, an art college, orders 50 oil color boxes from your store. However, it states that it cannot pay all the amount at once. 

    Considering this scenario, you allow the art college to pay later and accordingly make a credit sale agreement. After that, you sell 50 oil-color boxes to the art college on credit. According to the terms of your agreement, the customer (the art college) would take some time to pay your store in full for the oil colors. 

    Using the accrual concept, you will report the accrued revenue from the sale when you generate an invoice. The oil color boxes leave your store and not on the date in the future when the customer makes the complete payment.

    Is it feasible?

    Business transactions are often complex, especially for large businesses. Using the accrual basis of accounting serves as a solution to this complexity. Most large companies follow the accrual principle in accounting. Such companies sell products or services on credit and keep on receiving revenue over a long time from products or services sold in some previous period. 

    If these companies record their transactions when the payments happen, it will show an inaccurate picture of their financial position. The market requires an accurate representation of a company’s finances. So, the accrual accounting method allows large businesses to convey the most accurate picture of their financial position. 

    Moreover, investors prefer accrual accounting. A company that follows this method is often considered more well-established than otherwise.

    When a company wants to assess its performance for a specific period (such as a quarter or a financial year), the accrual concept in accounting proves to be efficient. 

    In the accrual basis of accounting, future revenues and expenses can be accounted for. In this way, the financial activities reported in the balance sheet allow the company to calculate crucial financial metrics such as operating margin, gross profit margin, and net income.

    A Few Limitations

    There are a few limitations to accrual accounting.

    Consider the example of Walter Harvey Pvt Ltd again.

    What if Walter Harvey never pays its supplier for the raw material? Or, what if it never gets paid for the products it has already sold on credit?

    Besides being a financial problem, this would also be an accounting concern. As the company follows accrual accounting, its books of account may indicate that it is generating profits. In contrast, the reported cash flows are still to be received. 

    In such cases, the company can be portrayed as profitable even if it lacks cash flow sufficient to run its day-to-day operations. Eventually, it may even get bankrupt, regardless of the profits shown on its financial statements.

    Moreover, accrual accounting might not be useful for small companies, considering that it requires a dedicated staff – an entire department to track and report revenues and expenses.

    Also, when a company records income even before the actual cash inflow, it may end up paying taxes on that income even before receiving it.

    The Bottomline

    Based on the matching principle, the accrual basis of accounting records revenues earned and expenses incurred for a specific period when products or services are delivered. It is beneficial for large businesses and market participants to provide a more accurate financial representation. However, it has a few limitations, mostly related to the representation not being the same as the reality. Overall, for precise reporting, the accrual concept is mostly preferred by large businesses and market participants.