Profitability depreciation

Cumulative cash position1 profit + depreciation -total investment ... 

Scrutiny of the balance sheet and the income statement reveals how much money flowed through the company how much profit was made how the funds provided by the net profit, depreciation, sale of common stock, and other items were used and how the cash generated affected the company operations. The changes in financial position show how the company managed its funds. 

Cash flow = Net profit + Depreciation = Revenue — Cash expenses - Income tax... 

PBT = (Depreciable fixed-capital + interests on total capital investment) / (profit + depreciation)cr. annuity... 

It should be noted that a capital allowance Is not a cashflow item, but is only calculated to enable the taxable income to be determined. The treatment of capital allowance for this purpose is a petroleum economics approach, which may differ from the accountant s view of depreciation when calculating net book values and profit. 

Possible numerators include the gross income net pretax income net after-tax income gross profit, ie, gross income minus book depreciation cash flow or net income. An average return value is selected by defining a typical or mature proof year as the basis of calculation. The denominator can be the original total investment, depreciated book-value investment, lifetime averaged investment, or fixed capital investment. 

The relationships among the various annual costs given by Eqs. (9-1) through (9-9) are illustrated diagrammaticaUy in Fig. 9-1. The top half of the diagram shows the tools of the accountant the bottom half, those of the engineer. The net annual cash flow Acp, which excludes any provision for balance-sheet depreciation Abd, is used in two of the more modern methods of profitability assessment the net-present-value (NPV) method and the discounted-cash-flow-rate-of-return (DCFRR) method. In both methods, depreciation is inherently taken care of by calculations which include capital recoveiy. 

FIG. 9-1 Relationship between annual costs, annual profits, and cash flows for a project. A d — annual depreciation allowance Acf — annual net cash flow after tax Ac/ = annual cash income Age = annual general expense Aqp = annual gross profit A/r = annual tax A e = annual manufacturing cost Avc/ = annual net cash income Avvp = annual net profit after taxes A/ p = annual net profit As = annual sales Apc = annual total cost (DCFRR) = discoiinted-cash-flow rate of return (NPV) = net present value. 

Since different meanings are ascribed to both annual profit and invested capital in Eq. (9-25), it is important to define the terms precisely. The invested capital may refer to the original total capital investment, the depreciated investment, the average investment, the current value of the investment, or something else. The annual profit may refer to the net annual profit before tax A vp, the net annual profit after tax Awp, the annual cash income before tax Aci, or the annual cash income after tax A vcf... 

Figures 9-6, 9-7, and 9-8 show the effect of the depreciation method on profit for a project described by the following data ...

FIG. 9-6 Effect of straight-line depreciation on rate of return for a project. Abd — annual depreciation allowance A c/ = annual net cash income after tax Awwp = annual net profit after payment of tax Cj = total capital cost. 

Let us consider plant eqmpment costing I million and purchased on Jan. I, 1988. T le 9-18 ows the provision for the depreciation account for 1988, 1989, and 1990 for straight-line depreciation, assuming a service hfe of 10 years and zero scrap value. The credit entries of 100,000 for the depreciation in each year are balanced by the depreciation charge of 100,000 debited to the income statement (or trading and profit-and-loss account) in each year. Table 9-19 shows the corre-... 

One of the most important items in an income statement is depreciation expense. Although depreciation should not be thought of as a means to build up a fund to replace plant, it nevertheless does enable money to be retained in the business by reducing the profit available for distribution to stockholders. It is of course a duty of both accountants and management to see that sufficient money is retained in the business to replace assets and to invest such money in other processes or outside investment. 

Row 2 in Table 9-24 is the profit margin (PM) of Eq. (9-127). In this case, the net profit referred to is the net annual profit after tax and depreciation Awp. The net sales is the revenue from annual sales As after deductions for returns, allowances, and discounts for gross sales. 

An income statement or profit-and-loss account gives the net annual profit A vp before tax. In order to assess the annual cash income Ac, as a source of funds from the value of the net annual profit A vp given in the income statement, it is necessary to add back all noncash expenses such as the balance-sheet annual depreciation charge Abd-This practice sometimes erroneously suggests that depreciation is a source of funds, whereas cash income is the only source of funds. 

The gross annual profit Acp in Table 9-36 is dependent on the balance-sheet annual depreciation charge Abd, whicm is not necessarily the same as the depreciation allowance used for tax purposes. Since Abd is arbitrarily chosen, it can be used to make the gross annual profit Agp high or low according to the company policy. 

Static and Flexible Budgets Overhead cost can significantly affect the profitability of a projec t and is the only cost outside the control of the project manager. The project is expected to contribute a definite amount toward the expenses of the company and will be charged this amount even if the production rate is zero. This is the fixecTcomponent of the overhead cost and will include directly allocable costs such as depreciation and a proportion of general costs such as office salaries and heating. 

As can be seen in Table 2 all revenues less expenses associated with selling are summed in Row 17. All expenses including noncash expenses such as depreciation, amortization, and depletion are summed in Row 30. The net profit before tax, Row 32, is obtained by subtracting Row 30 from Row 17 and making any inventory adjustment required. Row 34 is the cash taxes that are to be paid unless offset by investment or energy tax credits in Row 36. The deferred income tax is shown in Row 35. The deferred tax decreases the net profit after tax in the early years and increases the net profit after tax in later years. The impact on cash flow is just the other way around as discussed later. Row 37, profit after tax, is obtained as foliow s ... 

From an economic standpoint, electricity production from a new natural gas plant versus a newly built coal-fired plant heavily favors natural gas, because natural gas-fired plants are cheaper to build. However, older coal-fired plants built 20 to 30 years ago are often more profitable than newly built gas plants, because — among other reasons — coal is cheaper than natural gas, and the older plants have long since paid for their capital investments through depreciation. 

The annual depreciation of a fixed capital investment is referred to as annualized fixed cost. It allows the company to set aside an annual portion of profit and use it for purposes of capital-cost recovery and tax deduction. 

The net profit is the total income minus operating costs minus depreciation minus tax. The ROI is often calculated for the anticipated best year of the project the year in which the profit is greatest. This criterion is also used for small investments. In general, acceptable ROT are about 20 %, but typical values are difficult to give. Both POT and ROI provide a one-moment-in-time view and do not take into account future cash flows, which may not be constant in the lifetime of the venture. 

A summary of other pertinent costs in the states near customers is given in Table 2E-5. If it were known how each of these items affects the final cost, the various sites could be rated quantitatively. For instance, suppose the average energy costs are 2% of the selling price, before-tax profits are 30%, depreciation costs amount to 5%, and production labor costs are 10%. These items would reduce profits in Illinois by ... 

In determining profits for this case, no depreciation is included in the expenses. It is not necessary to assume a mature plant or to ignore startup expenses when using this method. Example 10-3 shows how to calculate the payout period for a plant that does not reach full production until the fourth year of operation. 

A company is considering which of two plants to build. Both plants cost 25,000,000. They will each earn pretax profits of 7,000,000 a year after 5 years of operation. The pretax profits (these do not include any depreciation expenses) of each plant are as follows ... 

Depreciation charges, which can be used in the same way as profits, should be treated in a similar way (see Chap. 11). 

Depreciation, amortization, depletion, and investment credit are all factors that affect the taxes a company must pay, and hence the profit that can be made. When the government wishes industry to change its direction, it can manipulate these factors to make certain options more profitable. The engineer must be aware of these changes, since they can be the deciding factor on whether a project should be continued. 

But earnings are not the only consideration. In 1968 the Union Carbide Corporation, along with many other companies, had a very bad year financially. In order to make its financial picture look better it switched from the double declining balance method of depreciation to the straight-line method. This reduced expenses (deprecitation being considered an expense) and hence increased profits. This is a semipermanent move, however, since a return to the double declining balance method would require approval of the Internal Revenue Service. 

The choice of cyclone modification, from an operating point of view, becomes a balance of incremental profit from increased conversion, versus catalyst makeup charges, and from a capital cost point of view, the price of either of the cyclone modifications, which must be depreciated. In many instances, there is an additional background time element, involving ongoing development of more attrition resistant and/or active catalyst. 

The longer it takes to build a facility, the lower its rate of return. Formulate the ratio of total investment I divided by annual cash flow C (profit after taxes plus depreciation) in terms of 1-, 2-, and 3-year construction periods if i = interest rate, and n — life of facility (no salvage value). 

The federal income tax on profits from corporations is based on income after all costs, including depreciation, have been deducted. Because depreciation affects taxable income, it is an important consideration in estimating profitability. The federal income tax rate for large corporations (profit greater than 75,000) was recently roughly 34-35 percent. State income taxes may push the total tax rate to about 40 percent. Therefore as an expense a depreciation amount of 1 reduces taxes about 0.40. At this level of taxation, the before-tax rate of return will be roughly 1.67 times the after-tax rate of return. 

Operating Profit/EBIT (2) Earnings before interests, tax, depreciation also contribution margin II (CM II)... 

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