The accumulated depreciation ratio refers to the portion of the value of total gross fixed assets that have already been covered by depreciation charges. The accumulated depreciation is the aggregate amount of depreciation charges made to the income statement, which reduce the historical value of fixed assets in the balance sheet.
What is the Accumulated Depreciation Ratio?
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This ratio is employed as a way to estimate the current obsolescence of a business’ fixed assets. This is possible since the accumulated depreciation grows as the average remaining useful life of the fixed assets decreases. Therefore, if the accumulated depreciation ratio is high, it means most of the assets are close to the end of their useful life and will soon become obsolete.
On the other hand, this ratio is also used to identify the need to determine when it is necessary or, at least, recommended to make new investments. A company that fails to renew its fixed assets on time may face severe productivity issues, as obsolete assets tend to produce less output than new ones.
Finally, a business can also estimate this ratio per asset, which will allow the management to identify which assets specifically have the highest ratio, to focus the efforts into renewing those initially.
A capital-intensive industry is one that is constantly demanding capital expenditures for businesses to operate adequately, as is the case for airlines and oil drilling. For these companies, tracking the accumulated depreciation ratio is particularly important, as they have to plan ahead in order to manage these assets in a way that the company remains operational and efficient throughout time.
Accumulated Depreciation Ratio Formula
The accumulated depreciation ratio formula is calculated like this:
Accumulated Depreciation Ratio = Accumulated Depreciation / Total Gross Fixed Assets
Accumulated Depreciation Equation Components
Accumulated Depreciation: The aggregate amount of depreciation charges inputted to the income statement, excluding those of assets that have been disposed, sold or declared obsolete.
Total Gross Fixed Assets: The total value of the business’ combined fixed assets at their historical value, which is usually the price paid for the asset plus any additional charges associated to the purchase such as import fees, installation costs, licenses, etc.
Also, the value of gross fixed assets can be determined by adding back the accumulated depreciation of a given time period to the net fixed assets of that same time period.
Accumulated Depreciation Ratio Example
Clinton Warehouses is a company that offers logistical services to businesses that deal with imported goods and also to e-commerce businesses that need to storage their goods somewhere, inventory handling services and fulfillment services. As part of the regular annual financial review, the CEO of the company decided to analyze the current situation of the business’ fixed assets. A big portion of these assets are inventory racks, pallets, transportation machinery and trucks. Currently, the company’s gross fixed assets add up to $123,000,000 and the accumulated depreciation is $76,000,000.
As a result, the accumulated depreciation ratio looks like this:
Accumulated Depreciation Ratio = $76,000,000 / $123,000,000 = 61.78%
Additionally, the asset’s average useful life is 5 years, which means that, on average, the assets have a remaining useful life of 2 years. The CEO decided it was a good time to consider new investments to renew some of these used assets and in order to do so he investigated the composition of the fixed asset portfolio further.
He found out that from the $123,000,000 in fixed assets currently in the books, at least 50% of that value came from the business’ truck fleet. These trucks have a useful life of 6 years and, on average, they were bought 4 years ago. He decided it was time to renew the fleet. In order to do so, the company sold a part of the current fleet and purchased brand new replacements for each of the sold trucks.
Depreciation Ratio Analysis
Analyzing the accumulated depreciation ratio provides a great opportunity to evaluated a business’ portfolio of fixed assets. A low ratio usually means that the business assets are mostly new, and they have little to no need to keep investing, unless the business is growing and incorporating new fixed assets is essential to continue growing.
On the other hand, a high ratio usually indicates that the fixed assets will soon be obsolete, and from an analyst’s standpoint, it will be a warning signal that the company may face a loss in competitiveness in the next coming years if the management doesn’t take immediate action to improve this situation.
In the example above, the CEO could identify through the accumulated depreciation ratio that the fixed assets portfolio was getting old and obsolete, but it wasn’t until he went further into the portfolio that he could identify the actual reason why the percentage was high.
Accumulated Depreciation Ratio Uses, Cautions, and Pitfalls
As many other financial indicators, the accumulated depreciation ratio cannot be used as the only variable to make a decision regarding the fixed assets portfolio. Understanding the composition of this portfolio is particularly important to understand why the ratio is resulting in certain figure.
On the other hand, there are also certain scenarios that should be considered when analyzing this ratio by itself. For example, a significantly low ratio may be normal in a startup or a new business venture, since assets have been purchased recently. An existing business with years in the market will usually have a ratio higher than 30%, any lower than that and it may indicate that the value of the fixed assets may have been adjusted upwards or the useful life of the assets has been overestimated.
Contrary to that, while a significantly high ratio may mean that the fixed asset’s portfolio is becoming obsolete, the reason for that could also be that there’s a handful of old assets that have a high value that haven’t been yet taken out of the portfolio. There could be a plan in place to replace them shortly and therefore the high ratio may not be necessarily a warning signal. In this case, it will be important to look further into what the company is planning to do in the near future regarding this situation.