As a budding entrepreneur, you might have carried out research about how to successfully run your business and also monitored the activities of your competitors.
But, what most entrepreneurs ignore is to have an in-depth understanding about the various departments which are potentially a part of their business.
Even if you belong in a creative field of work, it will involve dealing with a significant amount of finance. You may have sufficient knowledge about most financial concepts but there are some concepts that you must be comprehensively well versed with.
For any business, fixed assets and depreciation can be considered as the two most essential financial concepts to keep it ticking over smoothly. In order to understand their significance, you need to understand what they mean.
Here’s how you can know more…
What are Fixed Assets?
Fixed assets are business purchases utilised by the firm for a stipulated period of time. Land, machinery, equipments, etc. are counted as fixed assets. Unlike other business expenses, fixed assets offer a significant value in return when they are sold.
For instance, when a printing press owner invests in printing machinery then that machinery is considered to be a fixed asset. This is because, years later if he plans to sell off the machine he is entitled to receive a significant valuation on it.
Some entrepreneurs opt to take cash advance for business so that they can purchase new equipment and a new premises. Fortunately, there are some renowned and experienced firms which offer these services in the UK. This acts as a boon to many entrepreneurs as they can afford to expand their business without hampering cash flow.
Why are Fixed Assets Important for a Business?
Fixed assets are considered as a primary resource that indicates the net worth of any organisation on the balance sheet. Due to this reason, it becomes necessary to record, maintain and reconcile your fixed assets. An inaccurate representation of your net worth may tarnish your brand’s identity.
Apart from this, improper financial data can cost you investors, clients and customers in the long run.
What is Depreciation?
Depreciation can be termed as a gradual decrease of the original cost of the fixed asset. The cost decreases when it gets transferred from the balance sheet to the profit and loss account through the journal.
Depreciation can be considered as an expense caused through a fixed asset. This expense is a small percentage from the net cost of the fixed asset. With each passing year, the value of the fixed asset depreciates or reduces.
If you note fixed asset value in the current year and in the previous year’s balance sheet then you might know the difference. Depreciation is a simple calculation which is made once a year by every business.
The good part for small businesses is that their depreciation policy does not have major tax implications. HMRC has a different system for setting off fixed asset costs against tax which is coined as Capital Allowances.
Why is Depreciation Important for a business?
As mentioned previously, depreciation reduces the value of your fixed assets which means they also indicate how long they will run. This gives you a clear picture about how far you are from purchasing a new piece of equipment/machinery.
For example, if your company had purchased machinery in the year 2015, as per the depreciation amount calculated in 2016, 2017 and 2018 balance sheet you will get an estimation that the machinery will need to be replaced by 2020 max. This helps you to plan your business investments for the forthcoming years.
Apart from this, you are entitled to receive certain tax benefits due to depreciation. In a way, it reduces the company’s net worth as depreciation indicates a non-cash expense.
When a company has lower net income it will incur lesser tax liability. Sometimes companies accelerate their depreciation method in order to enjoy this tax benefit.
Ideally, there are two methods to calculate depreciation:
Straight Line Depreciation and Reducing Balance Depreciation.
o Straight Line Method
In this method, a fixed percentage is deducted from the value of the asset every year. For example, an equipment costing £1,000 is expected to last 4 years with an annual depreciation rate of 25%. This means that during the first year, £250 will be deducted as depreciation, during the second year, £500 will be deducted and this is charged to the Profit and loss statement.
o Reducing Balance Statement
In this method, there is a gradual deduction in value of the asset. For instance, if you have purchased an asset worth £8000 and its depreciation rate is 25% then in the first year its depreciation cost will be £2000.
In the second year, the depreciation will be calculated on the balance amount that is on £6000 and hence its depreciation value will be £1,500.