In previous articles of our series on the quick evaluation of investments we analysed how to calculate costs, expected profits, and then profitability itself to gain a clearer picture for our investment decisions. Each of the three aforementioned methods can be listed in the static investment calculation category. There is only one tool left: calculating depreciation.
Advantages of calculating depreciation
In this case we have to calculate the period over which our invested capital will be recovered. We can apply a simple formula for this in which we should define time in terms of years.
R=I/G where “R” indicates the recovery of the investment amount, “I” is for the one-off investment amount, and “G” stands for the annual profit.
Let’s take an example. The value of our investment is HUF 10 million (approx. EUR 32,000) and we would like to achieve an annual profit of HUF 2 million (approx. EUR 6,400).
R = HUF 10,000,000/2,000,000 (approx. EUR 32,000/6,400) = 5 years
The method is simple, and is used very frequently for investments. We can compare the required recovery period easily and quickly. But this is also its disadvantage, since it means the evaluation aspects can only include liquidity and security. The remaining term of the investment after the recovery period and the profit that it can generate are ignored here. An additional risk is that the formula does not take into account the period of the depreciation itself.
Where should we use the method for calculating depreciation?
Applying this method is mostly justified in the case of venture capital investments using external financing and for investments where we know the time of the asset’s replacement and its optimal useful life in advance.
It can be really useful if it is applied together with another investment evaluation method, for example, with the profitability calculation previously described, thus collectively they can form an appropriate basis for comparing the capital utilisation options.
Advantages and disadvantages of static investment calculation methods
Since calculating depreciation is the fourth and last static investment calculation method, it is worth evaluating the static procedure itself.
Its greatest advantage is manageability and transparency. We can obtain the necessary information relatively quickly. This is probably the most obvious method to assess traditional and smaller investments.
We can recommend static methods most easily for cases when you can fix the target figures and their components in your project in advance.
The disadvantage of static methods is that they cannot manage interdependencies between different areas of a company, they do not assess the relationships between the various investments, and do not assess temporal changes in profits or the useful life itself either.
To sum up, the static procedure is simple and easy to manage, but if the investment is supported with a more sophisticated IT and communication system then it can be mapped better with a more complex assessment method.