What it means
Depreciation spreads the cost of an asset, such as a machine or vehicle, across the years it is used. Each year a slice of the cost is charged against profit, even though no cash leaves the bank that year.
Profit after depreciation therefore understates the cash a business generates in a year. Pre-depreciation profit adds that charge back.
It gives a view of earnings that is closer to cash flow, and it makes it easier to compare businesses with different asset ages or depreciation policies. Two companies with identical operations can show different profits after depreciation if one uses faster write-off methods.
The figure is useful in lending. A bank wants to know whether the business can service debt, and it often looks at profit before depreciation, interest and tax as a measure of the cash available.
The debt service coverage ratio and similar tests rely on this sort of figure. It should not be treated as free cash.
Assets will eventually need to be replaced, and ignoring depreciation entirely can lead a business to overspend or underinvest. A company with a high pre-depreciation profit but heavy capital replacement needs may have little genuine surplus.
In practice, there are different definitions. Some use the term for profit before depreciation only, while others also remove amortisation (the equivalent charge for intangible assets) and so move close to EBITDA.
Always check what has been added back before comparing figures. A related practical point is tax.
Tax authorities often allow their own version of depreciation, so the profit used to work out tax can differ from the profit in the accounts. Finance teams usually keep a reconciliation so they can explain the gap to auditors and lenders.
In practice
Real-world examples.
Example
A haulage firm reports a profit of $90,000 after charging $140,000 of depreciation on its trucks. Its pre-depreciation profit of $230,000 shows the lender that the firm can comfortably meet its loan repayments of $150,000.
Example
A hotel owner compares two properties. One was bought recently and has large depreciation, while the other is fully depreciated, so the owner uses pre-depreciation profit to see which one performs better in operational terms. The older hotel looks weaker after depreciation than it really is, and the new one looks weaker for the opposite reason.
Example
A manager preparing a cash budget starts with pre-depreciation profit of $75,000 for the quarter and then subtracts planned capital spending of $60,000 to see how much surplus remains. The remaining $15,000 is set aside for tax and loan repayments.
Formula
Calculation
Pre-depreciation profit = Profit after depreciation + Depreciation charge
A small manufacturer reports revenue of $2,400,000, operating costs of $1,900,000 (excluding depreciation) and a depreciation charge of $180,000.
Profit after depreciation = $2,400,000 - $1,900,000 - $180,000 = $320,000.
Pre-depreciation profit = $320,000 + $180,000 = $500,000, which is simply revenue less cash operating costs ($2,400,000 - $1,900,000).Case study
Seen in the real world.
Westmoor Plastics is a fictional company that showed a small profit of $40,000 after depreciation of $260,000. The owners were disappointed and considered closing a production line.
The finance manager calculated the pre-depreciation profit as $300,000 and showed that the line was bringing in cash well above the profit figure. In this illustrative case, the owners kept the line open, but they set aside $200,000 each year in a replacement fund, since the machinery would need replacing in about five years.
The decision turned out well because the line later won a large contract. The owners also learned that profit after depreciation and available cash are different questions that require different numbers. The accountant added a one-page summary to the monthly pack showing both figures side by side, along with planned replacement spending. Staff in the production team said it was the first time they had understood why the finance figures changed so much from one measure to another. The owners now review both numbers before every investment decision, and they use the pre-depreciation figure when talking to their bank.
Watch out
Common mistakes.
- Treating pre-depreciation profit as cash available to spend, when assets will need to be replaced.
- Comparing figures from companies that define the measure differently.
- Forgetting that taxes and interest still have to be paid out of the profit, so the cash left over for owners is much smaller than the headline number.
Questions
People also ask.
Why add depreciation back?
Because it is a non-cash charge, so adding it back gives a figure closer to the cash the business actually generated.
Is pre-depreciation profit the same as EBITDA?
Not exactly, because EBITDA also adds back interest, tax and amortisation, while pre-depreciation profit may remove only depreciation.
Who uses this measure?
Lenders, owners and managers who want to judge cash generation, particularly in asset-heavy businesses such as shipping, hotels and manufacturing.
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