Unit 5 · Unit 5: Depreciation
Capex builds the asset base, depreciation grinds it down, and a non-cash expense quietly ties the income statement, cash flow, and balance sheet together.
Capital expenditure is the single driver that grows gross PP&E.
Property, plant and equipment (PP&E) is the stock of long-lived productive assets a company owns — factories, machines, fit-outs, servers, vehicles. It does not appear from nowhere: it is built up by capital expenditure (capex), the cash a company spends to acquire or improve those assets. Capex is therefore the primary forecast driver for the entire PP&E block. Get the capex assumption right and the asset base, the depreciation that follows, and a large slice of free cash flow all fall into place.
The accounting distinction that matters is capitalise versus expense. When a company spends on something that will generate value over many years, it does not run the full cost through the income statement in year one. Instead it capitalises the spend onto the balance sheet as an asset, then recognises the cost gradually over the asset's useful life as depreciation. That matching of cost to the periods that benefit is the whole reason depreciation exists.
Capex as a percentage of revenue A quick, durable way to forecast capex is to anchor it to revenue. If a company has historically spent 6% of sales on capex, projecting that ratio forward scales the asset base with the business and keeps depreciation realistic.
Straight-line versus accelerated — same total cost, different timing.
Depreciation spreads the cost of a long-lived asset across the periods it is used. Every method ultimately expenses the same total amount over the asset's life; they differ only in the timing — how much of the cost lands in early years versus later ones. The two families you must know are straight-line and accelerated (declining-balance).
Annual depreciation = (Cost - Salvage value) / Useful lifeThe simplest and most common method: an equal charge every year. A $100m asset with a $10m salvage and a 10-year life depreciates $9m per year.
Accelerated methods front-load the expense, recognising more depreciation early and less later. The most common form is declining-balance, which applies a fixed rate to the asset's remaining (net book) value each year. Companies often use accelerated methods for tax purposes — larger early deductions defer cash taxes — while reporting straight-line in their financial statements, which is one source of deferred taxes covered in the next unit.
Depreciation = Net book value at start of year × Depreciation rateDouble-declining balance uses a rate of 2 / useful life. Because it applies to a shrinking base, the charge falls each year.
| Feature | Straight-line | Accelerated (declining-balance) |
|---|---|---|
| Expense pattern | Equal each year | High early, lower later |
| Early-year net income | Higher | Lower |
| Typical use | Financial reporting | Tax / fast-obsolescing assets |
| Total expensed over life | Same | Same |
Timing, not total No depreciation method changes how much cash the asset cost or how much is expensed in total — only when. Choosing a method is a statement about how the asset delivers its value over time.
Gross PP&E rolls forward on capex and disposals; net PP&E is gross less accumulated depreciation.
The mechanics of a PP&E schedule are a roll-forward: you start with the opening balance, add what came in, subtract what went out, and arrive at the closing balance — which becomes next period's opening balance. PP&E has two roll-forwards running in parallel: one for gross PP&E (the original cost of assets) and one for accumulated depreciation (the running total of all depreciation charged). Net PP&E, the figure that sits on the balance sheet, is simply the difference.
Closing gross PP&E = Opening gross PP&E + Capex - DisposalsCapex adds cost; disposals (asset sales or retirements) remove cost at the original purchase price.
Net PP&E = Gross PP&E - Accumulated depreciationAccumulated depreciation rolls forward too: Closing = Opening + Depreciation expense - Depreciation on disposals.
The HLOOKUP waterfall trap In Excel, the CFA course builds this with a depreciation waterfall — each year's capex gets its own row, depreciated across columns, and an HLOOKUP/SUMIF totals the diagonal. It works, but a mis-anchored reference or a row inserted in the wrong place silently breaks the schedule, and the error often hides until the balance sheet won't tie.
A non-cash expense that hits the income statement, gets added back to cash, and shrinks net PP&E.
Depreciation is the cleanest example in all of modelling of a single line that touches every statement. It is a real expense — it reduces reported profit — but no cash leaves the business when it is recorded. The cash already left when the asset was bought (that was capex). This is what makes depreciation a non-cash expense, and why it behaves so differently across the three statements.
The tax shield Even though depreciation moves no cash itself, it is far from irrelevant to cash. By lowering taxable income it reduces cash taxes paid — the 'depreciation tax shield' — which is real cash kept in the business.
Linked automatically In the tool you never wire the add-back or the net-PP&E reduction by hand. Set a capex assumption and the engine builds the PP&E schedule with a PP&E floor, charges depreciation on the income statement, adds it back on the Cash Flow tab, and reduces net PP&E on the Balance Sheet — all in sync, with the balance sheet still tying via the plug.