What is Depreciation?

Depreciation is an accounting method that spreads the cost of a tangible asset over its useful life. Instead of recording the entire purchase price as an expense in one year, you deduct a portion each year, reflecting the asset's gradual decline in value.

Why Depreciation Matters

Depreciation serves two main purposes: it matches expenses to revenue in the periods when assets are actually used, and it provides tax benefits by reducing taxable income each year.

For example, if you buy a $50,000 delivery truck expected to last 5 years, you do not expense the full $50,000 in year one. Instead, you might deduct $10,000 per year over five years.

Common Depreciation Methods

The IRS allows several depreciation methods:

• Straight-line: Equal deductions each year over the asset's useful life — the simplest method
• MACRS (Modified Accelerated Cost Recovery System): The most common method for tax purposes, allowing larger deductions in early years
• Section 179: Allows immediate expensing of qualifying equipment up to annual limits (over $1 million as of 2024)
• Bonus depreciation: Additional first-year deduction for qualifying property

Depreciation and Cash Flow

Depreciation is a non-cash expense — it reduces your taxable income without requiring an actual cash outlay each year. When lenders calculate DSCR or cash flow, they often add depreciation back to net income because it does not represent a real cash expense.

This is why businesses with high depreciation expenses may show low net income but still have healthy cash flow.

Depreciation and Loan Applications

Lenders consider depreciation in several ways:

• Adding it back to income when calculating cash flow and DSCR
• Assessing the age and condition of depreciated assets offered as collateral
• Understanding your tax situation and effective cash position
• Evaluating capital expenditure needs for asset replacement

Book Value vs. Market Value

An asset's book value (original cost minus accumulated depreciation) may differ significantly from its actual market value. A fully depreciated piece of equipment might still be worth thousands of dollars.

When using assets as collateral, lenders typically consider market value rather than book value.