HOW FAR CAN THE CONCEPT BE STRETCHED?
size=2 color=black face="Times New Roman">To a limited extent, a profitability analysis that ignores depreciation is applicable outside the world of real estate.
In the broadcasting business, companies typically record depreciation and amortization expense that far exceeds physical wear-and-tear on assets. For example, when a company buys a radio or television station, the price reflects a comparatively small component of plant and equipment. The larger portion of the station’s value derives from its exclusive right to utilize part of the broadcasting spectrum, a scarce resource that tends to become more valuable over time. Much as in the real estate illustration, the broadcaster may show perennial losses after depreciation, yet realize a handsome profit when it finally sells the station. Instead of analyzing broadcasters on the basis of conventional net income, it is appropriate for analysts to focus on broadcast cash flow, usually defined as:operating income + depreciation and amortization + corporate overhead (A more meticulous calculation of broadcast cash flow deducts cash outlays for acquisition of new programming while deducting the amortization of the cost of previously acquired programming, both of which can be found on the statement of cash flows.)
The deliberate neglect of depreciation is an analytical option that should be used with discretion. In many industries, fixed assets consist mainly of machines or vehicles that really do diminish in value through use. The major risk of analytical error does not arise from the possibility that reported depreciation expense will substantially exceed economic depreciation, but the reverse.
Through a false analogy with real estate and broadcasting, any marginally unprofitable company in a capital-intensive business can declare itself to be in the black. The trick is simply to proclaim that analysts should no longer consider depreciation. Supposed earnings generated in such fashion, however, qualify as neither accounting profits nor bona fide profits.