Depreciation is the process by which a company’s capital goods lose their market value while being used in the company. Depreciation of the products mostly happens due to wear and tear while they are being used. Depreciation of machines and other capital assets in a company is calculated using the straight-line method and the accelerated depreciation method ( Ackermann, Fochmann, & Wolf, 2016) . This paper will analyze financial ratios affected by the depreciation of goods and how they are affected.
One of the financial ratios that is highly influenced by depreciation is the net profit margin. This ratio shows the amount made out of every unit cash generated as revenue. The ratio is calculated through the division of the net income by the total sales. Depreciation increases the cost of repair for the machines, and therefore, it reduces the net profit. Accelerated depreciation lowers net income at a longer rate than the straight depreciation method since it shows high depreciation rate.
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Return on assets is another ratio that is influenced by the depreciation. Return on assets involves the percentage profit that the company generates from its average assets during the year. This ratio is calculated through division of the net income to the average of the total assets during the year. Depreciation decreases both the book value of assets and also the net income ( Liao, 2016) . Straight-line depreciation method is also more preferred in this case, since it is the one that indicates a lower depreciation rate.
Moreover, depreciation also influences the debt to equity ratio, this ratio is calculated by dividing the total debt to the total equity. The debt to equity ratio shows the amount of income that a company generates from loans and credits versus the amount of income contributed by the company’s owners. Depreciation indirectly influences this ratio through a reduction in the number of earnings retained ( Liao, 2016) . At the early stage of depreciation, the straight line depreciation is more advisable since it indicates a lower depreciation rate while at the late stage of depreciation accelerated depreciation is advisable.
Finally, debts to assets ratio is also influenced by depreciation in that, the ratio is calculated by the division of the total debts against the total assets that the company has. When a machine in the company depreciates, its book value decreases. On the other hand, if the debt remains the same, the debt to assets ratio will increase. In this case, straight-line depreciation is advisable at an early stage of depreciation.
In the cases above for the users to maximize their profit margin, they should use the straight line depreciation rate while the product is at an early stage of depreciation. Meanwhile, at the late stage of depreciation they need to use the accelerated depreciation method. The same case should apply on the return on assets ratio if they want to show high returns on the assets that the company has. The procedure is also effective while dealing with the debt to equity ratio, in order for the company to be considered successful, the debt to equity ratio should be as small as possible, and consistently minimal hence the equity ratio would be high. Finally, every company wants a situation where the debt to asset ratio is small; to make this happen the rate of depreciation should be small. Therefore, financial statement users should apply the straight-line method at an early period of depreciation and use accelerated method at the late stage.
Reference
Ackermann, H., Fochmann, M., & Wolf, N. (2016). The Effect of Straight-Line and Accelerated Depreciation Rules on Risky Investment Decisions—An Experimental Study. International Journal of Financial Studies , 4 (4), 19.
Liao, D. (2016). Impact of Accelerated Depreciation of Fixed Assets Policy on Corporate Financing Behavior—Based on DID, the Empirical Analysis of the Model. Modern Economy , 7 (09), 1025.
