Pre-Depreciation Profit

What Is Pre-Depreciation Profit?

Pre-depreciation profit includes earnings that are calculated prior to non-cash expenses. Non-cash expenses appear as separate income statement expense line items, but no actual cash is spent on these items. Some common non-cash expenses are depreciation, amortization, depletion, stock-based compensation, and asset impairments. Pre-depreciation profit is a company's profit before writing down any depreciation or other non-cash expense.

Key Takeaways

  • Pre-depreciation profit includes earnings that are calculated prior to non-cash expenses.
  • Non-cash expenses appear as separate income statement expense line items, but no actual cash is spent on these items.
  • Depreciation costs are generally allocated according to a certain rate or percentage, depending on the depreciation method used.
  • There is a direct relationship between depreciation and profit, as well as some tax strategies that can be used.
  • Pre-depreciation is not to be confused with EBITDA, which includes actual cash charges.

Understanding Pre-Depreciation Profit

Pre-depreciation profit is calculated because it provides a cleaner number that can help determine a company's ability to service debt. Much like free cash flow, pre-depreciation profit is a measure of a company’s actual cash flow. Non-expense items lower a company's reported earnings, so a pre-depreciation profit would show a higher profit in comparison to profits calculated after depreciation.

Method and Calculation

Pre-depreciation profit is calculated before non-cash expenses, notably before depreciation. Depreciation allocates the cost of tangible assets over their economic and useful life. Depreciation is done for accounting and tax purposes and is recognized during the period the asset is expected to be used, starting as soon as the asset goes into service.

However, the depreciation method may vary, as will the length of time the asset is depreciated. The various depreciation methods may include declining balance or straight-line methods. It’s used to recognize the declining value or wear and tear of an asset. The pre-depreciation profit still includes various other cash expenses, such as marketing-related expenses, salaries, and rents. The convenience of the pre-depreciation profit is that it’s relatively easy to calculate. Just using the income statement, investors and analysts can calculate the pre-depreciation profit as a quick cash flow measure.

Non-cash expenses are reported on the income statement but do not involve the exchange of actual cash. Depreciation is the most common non-cash expense, with these non-cash items impacting the income statement and taxable income.

Depreciable items include vehicles, real estate (except land), computers, office equipment, machinery, and heavy equipment.

Example of Pre-Depreciation Profit

A company purchases a piece of equipment for $100,000. The company will depreciate the asset over 10 years, for the amount of $10,000 a year. The company’s depreciation expense of $10,000, a non-cash expense, would show up each year on the income statement, reducing taxable income. This item would not show up on the cash flow statement.

Pre-Depreciation Profit vs. EBITDA

Unlike earnings before interest, taxes, depreciation, and amortization (EBITDA), pre-depreciation profit is a profitability measure that is before non-cash charges. EBITDA is a profitability measure, also known as operating profit, but it includes actual cash charges. EBITDA is the earnings before non-cash depreciation, but this measure also excludes the cash charges interest and tax.

EBITDA is a measure of a company's overall financial performance that is sometimes used as an alternative to net income. However, the EBITDA number can be misleading because it strips out the cost of capital investments like property, plant, and equipment.

How Does Depreciation Affect Profit?

Depreciation has a direct relationship to a company's profit. Depreciation allows a company to expense the cost of an asset over time while reducing the carrying value of the asset. Depreciation is an allowable expense that reduces a company’s gross profit along with other indirect expenses like administrative and marketing costs. Depreciation expenses can be a benefit to a company’s tax bill because they are allowed as an expense deduction and they lower the company’s taxable income.

What Are the Main Methods to Calculate Depreciation?

There are four methods to calculate depreciation. They are straight-line depreciation, declining balance depreciation, sum-of-the-years' digits depreciation, and units of production depreciation. The straight-line method of calculating depreciation is the most commonly used and easiest to calculate.

Where Is Depreciation Shown on Financial Statements?

Depreciation is shown on an income statement as an expense. However, it is important to differentiate between depreciation and accumulated depreciation, as accumulated depreciation is shown on the balance sheet as a contra asset. Although they both pertain to items losing value over time, they appear in different sections on a balance sheet.

What Is the Difference Between EBITDA and EDITDAR?

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDAR is EBITDA, plus restructuring/rental costs. While EBITDA is much more commonly used, you might see EBITDAR applied when a company has recently restructured, typically within the past year. EBITDAR is also used by companies such as restaurants or casinos that have unique, highly variable rental costs.

The Bottom Line

Pre-depreciation profit is an income measure used to determine profit before incorporating non-cash expenses on a balance sheet. This is different from EBITDA, which includes actual cash charges. Pre-depreciation profit can be an easily digestible number used to determine a company's ability to service future debt.

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