One of the most difficult aspects of learning finance is the terminology. Two commonly used terms in the world of finance are the simple payback method and depreciation. The payback method calculates the amount of time it will take to repay a loan. Depreciation is used to write an asset off over its useful life instead of the year of purchase, which helps to smooth out net income over time.
The major use of corporate finance is to try to forecast or estimate cash flows. This is especially the case for loans or borrowed funds. If a company needs to borrow funds for a particular purpose it will use several measures to convince the lender to lend the funds. One particular measure, in addition to sales and income ratios, is the simple payback method.
The simple payback method provides a measure of the number of years it will take the company to pay back funds. For instance, if a company borrows $100,000 and will pay back $10,000 every 6 months over the life of the loan, it will take 5 years for the loan to be repaid. The calculation is Total Borrowed amount divided by Annual Repayment amount.
Depreciation is an accounting convention which serves two purposes: first, it helps to write off the value of assets over time, and secondly, it reduces the amount of income taxes a company has to pay. As a result, it takes some time to determine the most accurate depreciation expense. The most commonly used method is referred to as the straight line method.
Straight Line Method
The straight line method is common due to its simplicity and ease of use. It uses the assets useful life and the cost of the asset to determine the amount of the asset to write off every year. The calculation is Asset Cost divided by Useful Life. For instance, if you purchased a tractor for $100,000 and it has a useful life of 5 years the depreciation expense is $20,000.