# How to Determine Depreciation Rate

A small business will purchase long term assets (fixed assets) such as plant, machinery, fixtures, vehicles, and computers for use within it’s operations. With the exception of possibly land, all these long term assets have a limited life span due to wear and tear and obsolescence.

Depreciation is the name given to the expense charged to the income statement each accounting period to represent the reduction in value of these long term assets.

## What Method is used to Calculate Depreciation?

There are a number of methods used to calculate depreciation some of which are listed below.

• Straight line depreciation – the depreciation expense is the same amount each year and is based on the cost of the asset.
• Declining balance depreciation – the depreciation expense reduces each year and is based on the net book value of the asset.
• Double declining balance depreciation – the depreciation reduces each year and is based on the net book value of the asset at twice the straight line depreciation rate.

For simplicity, the financial projections template uses the declining balance depreciation method explained further below.

## Declining Balance Depreciation Method

The declining balance depreciation method, sometimes referred to as the reducing balance depreciation method, estimates the depreciation expense by applying a percentage depreciation rate to the net book value of the long term assets.

Declining balance depreciation = Depreciation rate x Net book value of the assets

As an example suppose a business purchases assets for 900 and applies a depreciation rate of 40% each year, then the declining balance depreciation for the five years of the financial projection would be as follows:

Declining balance depreciation schedule
Year Open Dep. 40% Close
1 900 360 540
2 540 216 324
3 324 130 194
4 194 78 117
5 117 47 70

For each year the depreciation expense is 40% of the opening net book value of the asset. For example in year 3, the opening net book value at the start of the year is 324, and the depreciation is 40% x 324 = 130, leaving a closing net book value of 324 – 130 = 194.

## How to Calculate the Depreciation Rate

Depreciation rates vary from industry to industry and from asset to asset.

The formula for calculating the declining balance depreciation rate is

Declining balance depreciation rate = 1 – (Salvage value / Cost)(1/Years)

So for example, if a business has purchased equipment with a value of 900 and expects it to have a useful life of 5 years (useful life) and an estimated salvage value of 70, then the declining balance depreciation rate calculation using the formula above would be as follows:

```Declining balance depreciation rate = 1 - (Salvage value / Cost)(1/Years)
Declining balance depreciation rate = 1 - (70 / 900)(1/5)
Declining balance depreciation rate = 40%
```

To simplify the calculation, typically the rate used would be two times the straight line rate or

Declining balance depreciation rate = 2 / Useful life

For example if the useful life of the asset is 5 years then a typical declining balance depreciation rate to use would be 2 /5 or 40%.

The following table shows the equivalent declining balance depreciation rate based on the useful life of the asset in years.

Typical declining balance depreciation rates
Life Rate
3 67%
4 50%
5 40%
10 20%
15 13%

## Depreciation and the Financial Projections Template

In the financial projections template one depreciation rate is set on the income statement for all assets. This is a simplification as for accounting purposes different assets are normally depreciated using different methods and at different rates. However, this is planning not accounting, and a simple average rate based on the useful lives of the assets of the business will usually suffice.

## Depreciation and the Cash Flow Statement

Depreciation is simply an accounting entry to represent the reduction in the book value of an asset over its useful life. Although it is included in the income statement as an expense and reduces net income, it does not involve the movement of cash and so is added back to net income in the cash flow statement.

## What’s the Next Step?

The next step in producing a five year financial projection for your business plan using our financial projections template is to find the interest rate to be used to calculate interest on debt finance.

This is part of the How to Create Financial Projections Guide a series of posts on how our template is used to produce simple financial projections for a business model plan.]