The Depreciation to Capital Expenditure Ratio
One ratio that may help an analyst understand if a company is overstating or understating its earnings is the depreciation to capital expenditure ratio. It provides information on how fast a company is recognizing its capital expenditures on the income statement. The ratio can give a misleading view though if the growth stage the company is in is not taken into account.
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Capital Expenditure
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A capital expenditure is when a company buys a fixed or long-lived asset such as machinery, buildings or properties. Capital expenditures are fully recognized for the full amount on the cash flow statement when they are purchased. However, they receive different treatment on the income statement under the Generally Accepted Accounting Principles (GAAP). On the income statement, the capital expenditures are depreciated not expensed.
Depreciation
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Depreciation is strictly for accounting purposes and the goal of it is to better match revenues with the relevant expenses. Depreciation is the gradual expensing of a fixed asset on the income statement. There are a number of different depreciation methods allowed by GAAP. The asset is depreciated over the lifespan of the asset as determined by GAAP. For example, a company buys a computer for $500. A computer has a lifespan of five years and the company chooses the straight-line depreciation method. The straight-line depreciation method states that the depreciation has to be the same amount each year for the life of the asset. The company has a depreciation expense of $100 for the next five years until the computer is fully depreciated and has a book value of zero.
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Depreciation to Capital Expenditure Ratio
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The depreciation to capital expenditure ratio measures how fast a company expenses its capital expenditures on its income statement. It is calculated by dividing the depreciation for a certain time period by the capital expenditure. The depreciation is found on the income statement, while the capital expenditure is found on the cash flow statement under the investment section. A company that is growing will have a ratio of less than one, a company that is in constant state will have a ratio of close to one, and a company that is shrinking will have a ratio of more than one. That is because a growing company will spend more and more money on capital expenditures while depreciation catches up. A constant-state company will spend the same amount on capital expenditures every year. A shrinking company will spend less and less on capital expenditures each year.
Use
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To find out if a company is overstating or understating its earnings, the depreciation to capital expenditure ratio can be compared to the company's historical figures, a competitor's figures or the life stage of the company. For example, if a company is in a constant stage and it has a ratio of less than one, that may imply that its depreciation rate is understated and earnings are overstated. If a growing company has always had a ratio of 0.8 and all of the sudden the ratio rises to 1.0, that may imply that the company's earnings may be understated because the company is depreciating its equipment at a faster rate than before.
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References
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