Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.
Businesses depend on having cash to meet expenses. Large purchases tend to be deducted on taxes over a period of years rather than just the year of purchase. We will discuss how depreciation for tax purposes affects a business' cash flow.
Depreciation and Cash Flow
Billy started a small landscaping business and bought a truck, a lawnmower, and other associated tools just for use in the company. Like any other business, Billy has to spend money on equipment that will eventually wear out and have to be replaced. Fortunately, depreciation allows Billy to save a bit on his taxes each year to account for this property, which is going down in value from age and use. And every dollar Billy doesn't pay in taxes is money he can use to grow his business.
Cash is essential to any business. In Billy's landscaping business there is never enough cash. He needs it to pay for things like gasoline for equipment, repairs, hiring part-time help, and making payroll in slow business times. A high cash flow would give the business the means to pay business commitments as they come up.
One of the liabilities coming due for Billy is taxes. Since tax payments eat into a business' cash flow, any deductions he can take reduce the amount of taxes due on the money he's made from mowing lawns.
It has been mentioned that depreciation can help Billy save money on his taxes, but what does that actually mean? Many of Billy's expenses can be written off the year they occur, like gasoline and replacement blades for the lawnmower. However, the tax code requires that any equipment that's expected to last more than one year be depreciated over its expected useful life rather than expensed.
The modified accelerated cost recovery system, or MACRS covers how different items are depreciated in the US tax system. Under MACRS, different items are assigned to classes based on how long each item is expected to last. For example, a computer is expected to have a relatively short useful business life of three years, while a commercial building has a useful life of 39 years, according to the IRS. The comprehensive listing of classes and guidelines can be found in IRS Publication 946.
In Billy's case, his business truck would be depreciated over five years and his lawnmower over seven years. So if Billy buys a new lawnmower for $2,000, rather than getting a $2,000 deduction that tax year, he gets to deduct 1/7th of $2,000, prorated to the month he bought the mower. Let's say he purchased the mower on July 1st, halfway through the year. This means he would get to deduct approximately $143 on his taxes that year: ((2000/7) x .5). Then over the next six years he would deduct approximately $286 per year. Finally, in the eighth calendar year after he bought the mower, he would be able to take the deduction for the last six months of the seven-year depreciation allowance, or $143.
Book Value and Market Value
Each depreciable item in a business has its own MACRS accounting sheet. The price paid for the equipment sets the initial book value. Each year when the business completes its tax return, the book value is decreased by the amount of depreciation taken. So six months after Billy bought that $2,000 lawn mower, it now has a book value of $1,857 ($2,000 - $143). The following January it would have a book value of $1,571 ($1,857 - $286). The book value continues to drop each year until the item is fully depreciated and reaches a book value of $0.
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Billy's assets include cash, but they also include vehicles and equipment that could be easily sold for cash. Thus, as the book value of an item decreases, so does the business' total asset values. This means that unless the business brings in more cash to offset the difference, its net working capital will likely decrease despite having the extra cash on hand from the tax savings. Net working capital refers to a business' assets minus its liabilities.
However, there's another way of valuing an asset: market value. The market value of depreciable property is whatever a potential buyer is willing to pay for it. This may be higher or lower than the book value used for depreciation for tax purposes.
The main reason to compare book value and market value is if the owner is considering selling the equipment. If someone like Billy sells the equipment, the difference between those two values will affect taxes. If the book value is higher than the actual sale price, a loss can be claimed on taxes, which would reduce the taxable income. If the book value is below the actual sale price, then technically the equipment was sold at a profit, and taxes are owed on the sale.
Depreciation Effects on Cash Flow
Depreciation allows business owners to save on taxes each year by taking a loss against physical assets. On tax returns, depreciation has the effect of acting like an expense without requiring an actual cash outlay, since Billy can claim depreciation for a piece of equipment that may have been purchased two or three years ago, these savings allow Billy's landscaping business to hold onto more cash over time, improving overall cash flow.
A company's cash flow represents the amount of cash the business has to meet its debts and commitments. The MACRS depreciation method allows businesses to take a paper loss each year for equipment with a useful life over one year, to account for the equipment losing value from age and use. These items have a book value based on the initial purchase price minus annual depreciation, whereas their market value is just what the item is worth to a prospective buyer. The difference between these two values affects the taxable gain or loss when the equipment is sold.
These paper losses do not actually require the business owner to spend money after the initial purchase, but provide offsets against future years' taxable income. This reduces the amount of cash going out of the business, which leads to a higher cash flow. Depreciating assets reduce the value of total business assets each year, which may reduce the net working capital. A decrease in net working capital may be offset by putting the money left in the business back to work to generate more cash revenue.
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