In today’s post, we will focus on explaining the specifics of the accumulated depreciation ratio. We’re talking about a fixed assets ratio that calculates the value, age, and usefulness of the fixed assets present on a firm’s balance sheet. In essence, these are compared in relation to the total amount of depreciation taken on by those assets considering the total carrying costs.
What is the Relation Between the Accumulated Depreciation Ratio and the Fixed Assets Ratio?
The accumulated depreciation is a contra asset account that entails the value lost on a given asset over the course of time, as it ages and its usefulness diminishes. By comparing and contrasting the value of the assets, a firm can assess their current value, and, most importantly, the existing useful value of the given assets.
Some examples of fixed assets are the machinery and equipment utilized by a company for generating profit and conducting services. Depending on the specific type of asset, distinct depreciation schedules could apply. This is, presumably, the most critical element when it comes to calculating this ratio; therefore, it should be monitored attentively.
With that in mind, investors and managers alike utilize this formula to assess the productiveness level of a firm’s invested capital, in the form of fixed assets. A low ratio outlines that the assets could be used for many years to come. On the other side, a high ratio means the exact opposite.
The formula of the accumulated depreciation ratio implies dividing the total accumulated depreciation by the total amount of fixed assets. It is essential not to incorporate the land in the fixed assets number. That’s because land cannot be used up. Aside from that, land will always be valuable; therefore, it cannot be depreciated over time.
As a rule of thumb, analyze the balance sheet for you to proceed with making the calculation.
Analyzing the Formula
Deciding whether a number is bad or not will depend on the type of asset and how long it has been owned. Now, considering that a firm has bought the assets last year, a 30 percent drop could trigger some concerns. This could happen due to a combination of factors. A common scenario might be the following: the asset simply has a short lifespan and the company might utilize a slightly aggressive depreciation schedule.
Other elements that could play a part in affecting the ratio include the firm’s financial ability to replace worn machinery and equipment. Without enough capital, this number is likely to keep going up, as assets continue to age. Fundamentally, this might be a reason why the company could be seeking a loan to cover the costs of new equipment and machinery. It would be highly recommended for a company to compare this ratio in relation with former years. This is specifically why banks usually require financial statements from subsequent years.
Ultimately, the accumulated depreciation ratio is definitely useful, as it was clearly shown in the former paragraphs. Nevertheless, you should keep in mind that it is relative to the firm’s industry standards and line of business. Thus, you shouldn’t overlook this critical element during your evaluations.