Fixed Assets, including machinery, buildings and automobiles, are essential to the business model of many companies. Unfortunately, these assets lose value over time and will need to be replaced. To account for the loss, a business must write off portions of the asset’s value as depreciation. The depreciation to fixed assets ratio measures just how quickly a company is writing off those assets and may give clues on how fixed assets are being managed.
Depreciation is one of those expenses that doesn’t take cash out of the business. It really is an acknowledgment, by the business, that it has lost some value from the aging, wear, and tear or obsolescence of its fixed assets, therefore, a portion of the gross income is set aside to cover this phantom expense.
Without depreciation charges, businesses would be overvalued. To illustrate, lets assume that a business had purchased a brand new vehicle ten years ago for $30,000 and it is the only asset it has. Let's also assume that no depreciation was charged over the ten-year period. The books would show that this fixed asset was valued at $30,000, but since the car can only be sold for $7,000 at today's prices, the business would be overvalued by $23,000.