When you purchase supplies the transaction is an easy one from an accounting stand point. You use cash, credit card or vendor credit to make the purchase and report the supplies as an expense on your income statement. Most business transactions in accounting make sense. But one that trips up business owners and students is the concept of Depreciation.

Unlike the purchase of supplies the purchase of a large asset, such as a car, is “capitalized”. What this means is that you don’t recognize the full cost of the car as an immediate expense. Instead, you report the value of the car on the Balance Sheet as an asset. You should have a corresponding debt for the car in the liabilities section of the Balance Sheet, unless you paid cash for it. Then you determine the life of the asset, cars are generally considered to have a useful life of 5 years for depreciation purposes. As such, the cost of the car would be allocated to the income statement for each of the next 5 years. We’ll ignore the Balance Sheet aspects for now.

Depreciation is what we commonly refer to as a “non-cash” expense. Continuing with the car example, if we pay for the car with cash our cash outflow is in the first year, yet we allocate the cost of the car over 5 years. Which means that the profitability of your company is going to be impacted by the depreciation even if you no longer have any car payments because the payment of the asset and the allocation of depreciation expense do not take place simultaneously.

Depreciation allows you to better match the useful life of the asset with the revenue you are generating due to the benefits produced by that asset. If you were to expense the entire value of the asset in the year of purchase your profits in that year would be unnecessarily low and future years too high.

There are many ways to measure the profitability of your company. Income taxes are calculated based on net income, including all non-cash expenses. Whereas you can also look at cash basis profitability which would only include items that actually increase or reduce cash. Sometimes business owners like to see a line item on their income statement that is commonly called EBITDA (earnings before interest, taxes, depreciation and amortization). Another approach that I use for my clients is EBDA (earnings before depreciation and amortization) so that they can compare their net profits with non-cash expenses included to their net profits based mainly on cash only items. Figure out what works for you and use that as a measure to determine your monthly, quarterly and yearly goals.