What is Accumulated Depreciation to Fixed Assets Ratio?
The accumulated depreciation to fixed assets ratio is a measurement to compare the amount of depreciation for a physical asset with its total value. In accounting, depreciation is a method that calculates the cost of a physical asset over its life expectancy. The number that comes from depreciation shows how much of the asset has been used. In other words, the accumulated depreciation ratio indicates the overall remaining usefulness of an asset.
Most physical assets owned by an entity, whether an individual or corporation, will most likely decrease in value over time after being used. If you were to sell your laptops, phones, or TVs, you will usually get a lower amount of money compared to the amount you pay when you buy them.
This happens because your assets are depreciated over time, thanks to wear and tear. Accumulated depreciation to fixed assets tries to estimate how much value these tangible assets have been lost compared to its original cost by these wears and tears.
Accumulated depreciation is only an estimation and does not reflect the price at which the asset can be sold. Normally, the value of accumulated depreciation can be found on the balance sheet.
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.
ADTFA = Total Fixed Assets ÷ Accumulated Depreciation
To start with, we need to know the value of the asset’s accumulated depreciation. To calculate this variable, several methods can be used. Each company adopts one of these methods. One such method is called straight-line depreciation. Apparent from its name, this method estimates an asset depreciation in a straight manner. For instance, a car is depreciated by $2,000 each year over its estimated useful life, let’s say seven years. In this case, after seven years, the value of the car is depreciated by $14,000 from its initial value.
The next variable we need is the value of total fixed or physical assets. Physical assets are economic material that has real-world existence and directly contributes to businesses to generate revenue. Things such as cars, buildings, and computers are some of the examples of physical assets. These assets are not intended for sales and typically stay with businesses for as long as they can or if they decide to replace them. However, if these assets are intended for sales by some companies like electronic shops or vehicle shops, they are considered inventory.
Often, people refer to physical assets as fixed assets, both of which are part of tangible assets. These two terms are usually pointing to the same thing: property, plant, and equipment (PP&E). PP&E value can be found on the balance sheet and that’s the value we use for the total physical assets variable.
One important thing to note is that we don’t include lands when evaluating the accumulated depreciation ratio of physical assets. While land is still a part of PP&E they typically don’t depreciate. This is contradictory to other assets in PP&E, so be careful not to include lands in your calculation.
An accountant for a company wishes to determine the accumulated depreciation ratio for her company’s physical assets. To do this, she needs to review the variable needed from the balance sheet. The value of property, plant, and equipment (PP&E) save for lands is found out to be $40,000. On the other hand, the value of accumulated depreciation from these assets is $15,000. What is the accumulated depreciation ratio?
- Total physical assets: $40,000
- Accumulated depreciation: $15,000
We can apply the values to our variables and calculate the accumulated depreciation to fixed assets ratio:
In this case, the accumulated depreciation to fixed assets ratio would be 0.375 or 37.5%.
From this result, we can conclude that the physical assets or fixed assets of the company have been, overall, depreciated by 37.5% from their original costs. Keep in mind that these results are aggregated and don’t reflect each of the depreciation of the assets. Some of them would have a higher or lower accumulated depreciation ratio individually.
Analysis and Interpretation
Depending on the type of asset and how long it has been owned, this may not be a bad number. If the company just purchased the assets last year, however, a 30% drop in value may seem concerning. This could be caused by a couple of different things. The asset may really have a short lifespan but this may also be a sign the company is using an aggressive depreciation schedule.
Other factors that may influence this ratio include the company’s financial ability to replace worn machinery and equipment. Without sufficient capital, this number may continue to climb, as assets continue to age. This could be why the company is seeking a loan to cover the cost to purchase the new machinery.
It would be useful to compare this ratio with previous years for this company, which is why banks usually want to see several years’ worth of financial statements to review. Steady rates over time would likely signal the status quo works, while wild fluctuations in this rate would warrant more investigation.
Accumulated depreciation ratio can be an essential tool for companies that want to estimate the general remaining usefulness of their physical assets. If they see that the ratio is too high for comfort, they can opt to investigate which assets mostly contribute to the large depreciation ratio. Then, they may replace these assets efficiently by selling and replacing them or by purchasing them with loans.
Accumulated depreciation in itself as part of the accumulated depreciation ratio equation is also important. Companies implement depreciation for their assets for accounting and tax reasons. Depreciation is part of contra assets, which is a negative account that paired with each of the appropriate assets. Depreciation doesn’t cost companies anything but it still contributes to reducing companies’ revenue. With reduced revenue, companies can lower the potential taxes that need to be paid. This aspect is one of the most attractive things about accumulated depreciation for businesses.
Please note that corporations still need to comply with the generally accepted accounting principle (GAAP) when calculating the variable. They cannot give an arbitrarily value to accumulated depreciation to further decrease tax.
One last thing to note is that the accumulated depreciation ratio may not provide an accurate picture if accumulated depreciation is not calculated properly. Companies may have very little or very big metrics compared to their assets’ real condition so they may be either replacing these assets too soon or too late. Both possibilities may cost money than needed.
Practical Usage Explanation: Cautions and Limitations
While financing the machinery is not in itself a poor decision, other concerns like other debt obligations begin to enter the picture. When evaluating accumulated depreciation to fixed assets, keep in mind more financial analysis is necessary to make judgment calls.
Low metrics are not necessarily a good sign either. For example, a company with very little accumulated depreciation over several years may not be accounting for depreciation accurately or may be spending huge amounts of money replacing fixed assets too soon.
Accumulated depreciation itself is used to adjust the book value of a company, so knowing the relationship it has with fixed assets that add to, rather than detract from, the value of the company is important.
Ultimately, the accumulated depreciation to fixed assets ratio, like many other financial calculations, is relative to the company’s line of business and industry standards. Keep this in mind when evaluating.
- The accumulated depreciation to fixed assets ratio is a metric indicating the portion of accumulated depreciation of total physical assets or fixed assets.
- This formula requires two variables: accumulated depreciation and total physical assets.
- Physical assets—or fixed assets—are usually recorded on the balance sheet as property, plant, and equipment (PP&E).
- Companies use the accumulated depreciation ratio to get a general outlook of their physical assets’ remaining usefulness.
Frequently Asked Questions
What is the accumulated depreciation to fixed assets ratio?
The accumulated depreciation to fixed assets ratio is the portion of accumulated depreciation on total physical assets or fixed assets.
How is accumulated depreciation to fixed assets ratio calculated?
The accumulated depreciation to fixed assets ratio is calculated by dividing the accumulated depreciation by the total assets.
The formula is:
ADTFA = Accumulated Depreciation Total Fixed Assets
What is a good accumulated depreciation to fixed assets ratio?
There is no definitive answer to this question as it depends on the company and their individual circumstances. However, the lower the ratio, the better as it suggests that the physical assets have been depreciated less.
What is the relation between the accumulated depreciation ratio and the fixed assets ratio?
The accumulated depreciation to fixed assets ratio is a component of the fixed assets ratio. The fixed assets ratio is calculated by dividing the total fixed assets by the net income.
What is the importance of accumulated depreciation to fixed assets ratio?
The accumulated depreciation to fixed assets ratio can be an essential tool for companies that want to estimate the general remaining usefulness of their physical assets.
If the ratio is too high for comfort, companies may replace these assets. Additionally, the accumulated depreciation ratio helps companies reduce their taxable income. However, it is important to note that this metric may not be accurate if accumulated depreciation is not calculated properly.