How to evaluate depreciation and interest costs of cos

In the previous article of this series, we had discussed operating margins and how one can gauge the same. In today's article, we will take a look at the items that come below operating profits - depreciation and interest costs.

Depreciation: Overtime, assets lose their productive capacity due to reasons such as wear and tear, obsolescence, amongst others. As a result, their values deplete. Companies need to account for this depletion in value. This amount is called depreciation expense. Depreciation can also be viewed as matching the use of an asset to the income that it helped the company generate. It may be noted that it only represents the deterioration in value. As such, this expense is not a direct cash expense. There is no outflow of cash.

Depreciation is commonly accounted in two ways – straight line and written down value. The straight line method divides the cost of an asset equally over its lifetime. An example will help us understand the process better. Suppose a company buys equipment worth Rs 10 m in FY11. This equipment is expects to have a lifeline of a decade (10 years). As such, the depreciation rate would be 10% i.e. Rs 1 m (Rs 10 m * 10%). Therefore, the company will show depreciation charge (for that asset) as Rs 1 m each year.

Year	Value of asset (Rs m)	Depreciation Amt (Rs m)
FY11	10,000,000	1,000,000
FY12	9,000,000	1,000,000
FY13	8,000,000	1,000,000
FY14	7,000,000	1,000,000
FY15	6,000,000	1,000,000
FY16	5,000,000	1,000,000
FY17	4,000,000	1,000,000
FY18	3,000,000	1,000,000
FY19	2,000,000	1,000,000
FY20	1,000,000	1,000,000
FY21	0	-

Under the written down value (WDV) method, companies depreciate the value of assets using a fixed percentage on the written down value. The written down value is the original cost less the depreciation value till the end of the previous year. As such, this results in higher depreciation during the earlier life of the asset and lesser depreciation in the later years. An example of the same is shown below:

A company buys an asset worth Rs 10 m in FY11. It will depreciate the value of the asset by 15% each year (on the written down value).

Year	Value of asset (Rs m)	Depreciation Amt (Rs m)
FY11	10,000,000	1,500,000
FY12	8,500,000	1,275,000
FY13	7,225,000	1,083,750
FY14	6,141,250	921,188
FY15	5,220,063	783,009
FY16	4,437,053	665,558
FY17	3,771,495	565,724
FY18	3,205,771	480,866
FY19	2,724,905	408,736
FY20	2,316,169	347,425
FY21	1,968,744	295,312

The key difference between both these methods is the actual amount of depreciation per year. However, it may be noted that the total depreciation costs (over the life of the asset) will be the same using either of the methods.

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Coming to the point of how much depreciation a company charges, it mainly depends on the type of asset. As mentioned earlier, depreciation is charged on assets due to reasons such as obsolesce, wear and tear, amongst others. Fixed assets such as software and computers would be depreciated at the highest rate as they tend to get obsolete rapidly due to technology upgrades and updates. Plant and machinery would attract a lower depreciation rate due to their longer life. It may be noted that companies do mention the depreciation rates they take on their fixed assets in their annual reports.

Another point to be noted is that some companies show depreciation costs as part of operating expenses. As you would have guessed, depreciation does not form part of the core operations of a company. As such, it would be a better method to calculate depreciation separately (after calculating the operating income) and not include it as part of operating expenses.

As such understanding what method is used for computing depreciation is essential when it comes to equity research and analysis. The reason for this is that the method of depreciation has a direct impact on the net profit for the year. For instance if the company uses the straight line method, then it shows lower depreciation expenses in the initial years of the asset’s life. Lower expenses means higher net profits. The reverse happens in the case of written down value method. So if a company is aggressive in its financial reporting, it could resort to using SLM.

Interest costs: Interest costs are the compensation that a company pays to banks or lenders for using borrowed money. These costs are usually expressed as an annual percentage of the principal, also known as the interest rate. As you may be aware, interest rate is dependent of variety of factors such as the credit risk of the company, time value of money, the prevailing global interest and inflation rates, amongst others.

Any investor would prefer a company which is debt free. But this is not to say that companies with a certain amount of debt make bad investments. If a company is easily able to cover its interest costs within a particular period, it could be a safe bet. How can we know that? This is where the interest coverage ratio comes in. The interest coverage ratio is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period.

For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20 m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the greater are the risks.

A very important point for investors is to figure out whether interest costs are being capitalized. As per accounting standards, companies are allowed to capitalize their interest costs on debt taken to expand their asset base. As such, during period of capacity expansions, interest cost may seem to be lower as a certain amount of the interest component is being included in the gross fixed assets of the company. This is something investors need to keep in mind when gauging such parameters.

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