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Ploughing Back the Profits
What it means when we say that depreciation generates internal funds ...
Here is a question I received the other day and my response to it: it concerns how depreciation can be seen to be used for raising internal funds: ploughing back the profits we used to call it!
Date: 31/1/2002
Glyn Jones
From: Glyn Trevor Jones
Subject: hello I need help for college work
I'm a student in ... North Wales and I need help would you be able to tell me how you can use depreciation for raising internal funds your info would be very helpful thank you for your time
A fairly straightforward question; and here is my fairly straightforward answer!
Date: 2/2/2002
Hi, Glyn
What is normally meant by the question you've asked is that by providing for depreciation, an organisation reduces the amount of profit and because of that reduces the amount of money that is likely to be paid out in terms of dividends.
An example should help to clarify this point: here we have the Profit and Loss account of DW Ltd shown twice:
Subject: re: hello I need help for college work
| DW Ltd Profit and Loss a/c for the year ended 31 January 2002 | ||
| Gross profit b/d |
100,000
|
|
| Less: expenses (excluding depreciation) | ||
| Administration |
25,000
|
|
| Selling |
10,000
|
|
| Distribution |
7,500
|
|
| IT |
12,500
|
|
| Finance |
5,000
|
|
| Total expenses before depreciation |
60,000
|
|
| Provision for depreciation |
15,000
|
|
| Total expenses |
75,000
|
|
| Net Profit before taxation |
25,000
|
|
| Taxation |
5,000
|
|
| Net profit after tax, available for distribution |
20,000
|
|
We can see here that DW Ltd has ?20,000 from which to pay its dividends; and we will assume that the full amount available WILL be paid out as dividends.
| DW Ltd Profit and Loss a/c for the year ended 31 January 2002 | ||
| Gross profit b/d |
100,000
|
|
| Less: expenses (excluding depreciation) | ||
| Administration |
25,000
|
|
| Selling |
10,000
|
|
| Distribution |
7,500
|
|
| IT |
12,500
|
|
| Finance |
5,000
|
|
| Total expenses before depreciation |
60,000
|
|
| Provision for depreciation |
-
|
|
| Total expenses |
60,000
|
|
| Net Profit before taxation |
40,000
|
|
| Taxation |
7,500
|
|
| Net profit after tax, available for distribution |
32,500
|
|
Now that there is no depreciation to be provided for, we can see that DW Ltd's total expenses fall to ?60,000 but the profit before taxation and the profit after taxation have both risen.
The outcome of this second example is that the Net profit after tax, available for distribution is now ?12,500 higher than before.
Consequently, if DW Ltd paid out all of the available profit as cash dividends, they would use ?32,500 IN CASH to do that. On the other hand, when DW Ltd provides for depreciation, as in the first example, the total amount it would have paid out in dividends would have been only ?20,000, assuming again that it pays out the whole of the profit in dividends that it could have paid out.
From this, we can see the answer to you question "how can you use depreciation for raising internal funds?" becomes clear:
Providing for depreciation reduces the amount of profit available for distribution; and by doing so, it retains cash in the business; hence the cash that is left in the business can be used for other purposes ... in theory at least, in providing cash for future investment in fixed assets.
The question you asked, Glyn, concerns what used to be called ploughing the profits back into the business: retaining profits, and cash, along the lines shown in this example.
I hope that is clear for you Glyn; but let me know of anything that's not clear; and don't forget to tell me how it has helped you in your coursework.
Best wishes
Duncan Williamson
© Duncan Williamson
2 February 2002
© Webmaster Duncan Williamson 2002