Capital Punishment for Business Owners: Why Depreciation Isn't a Fake Expense

How awesome is depreciation, amirite?! It’s that little “non-cash” expense on your income statement that you don’t even have to pay, but the IRS lets you mark it as an expense you can deduct from your taxable income. Does it get any better than that?

Investopedia says, “Depreciation is a crucial accounting practice that spreads the cost of expensive assets, like equipment, across their useful life. This helps businesses avoid the appearance of financial loss from large upfront expenses and matches the cost of assets with the revenue they generate over time.”

From a financial perspective, this makes sense. If you have a large capital expenditure every couple years, cash accounting would fall short in reflecting your true year-to-year profitability. The year you bought that $200,000 piece of equipment may reflect a big “loss” for your business, but this asset will be used for years to come. So, even though we may have already paid the $200,000 in cash, our net income statement may show $20,000 in depreciation each year for 10 years, smoothing out our annual profitability.

While Investopedia and many accountants stop there — simply describing depreciation as “spreading the cost” of an existing purchase — we believe depreciation goes much further. If you ignore what this “non-cash” expense is truly telling you about your business, you may experience a similar fate as Frontier Communications.

Frontier Communications

You’re all probably familiar with Frontier, which started as a collection of small rural telephone companies and grew into one of the largest internet providers in the United States. In 2016, Frontier took on a lot of debt to purchase Verizon’s operations in California, Texas, and Florida, which tripled the company’s size. Management said this acquisition of largely tangible assets and infrastructure would generate strong cash flows.

While AT&T and Verizon aggressively reinvested profits to replace aging assets and build out their fiber infrastructure, Frontier had large debt obligations and decided to use profits towards paying heavy dividends to shareholders while keeping CAPEX low and cutting operational costs. This Wall Street short-termism is all too common and ended up costing Frontier massively. By neglecting the need for CAPEX to upgrade existing assets and build out fiber infrastructure, the company’s service deteriorated quickly, resulting in heavy reputational damage.

The company began suffering massive and accelerating customer losses and was eventually forced to write-down the value of their acquired assets, wiping out all shareholder equity and pushing the company into bankruptcy. Then the lenders took over control of the company. Frontier assumed that acquiring these hard, deteriorating assets was sufficient in maintaining their market share position. After all, EBITDA (what Charlie Munger referred to as “bullshit earnings”) was still over $3 billion. But EBITDA ignores two critical factors: debt and depreciation.

EBITDA (earnings before interest, taxes, depreciation, and amortization) not only ignores the annual interest cost of debt (which appears on the income statement), but also ignores the annual principal payments of debt (appears on the cash flow statement). EBITDA also adds back depreciation since it’s a “non-cash” expense. EBITDA, which many Wall Street investors and business owners track routinely and use to value their businesses, is NOT cash flow. It can be highly misleading.

In plain English, Frontier decided to pay for depreciating assets with someone else’s money in the future while paying banks interest in order to do so. They then chose to cut operational costs to make up for their heavy debt burden. Lastly, they pulled money out of the business to pay owners dividends rather than reinvesting into core assets that drive the business’s growth. If Frontier were wise, they wouldn’t have seen depreciation as just an accounting line item that reflects an existing, non-cash expense, but as a signal for significant FUTURE asset replacement costs.

Maintenance CAPEX vs. Growth CAPEX

Investments in your business are not created equal. Many business owners may not be familiar with the difference between maintenance CAPEX vs. growth CAPEX. When one of your trucks breaks down and you need to buy a new one, are you truly “reinvesting” in your business?

When we pay for COGS, pay the IRS taxes, or when we make payroll, we don’t say we’re “reinvesting” in our business, do we? No, because these are all required to stay in business. The same is true for maintenance CAPEX. Depreciation is the accounting signal telling you that your assets are depreciating and you’ll have to replace them in the future.

On the other hand, growth CAPEX comes from free cash flow — after we’ve paid maintenance CAPEX. It’s buying MORE trucks. It’s starting a NEW marketing campaign. It’s hiring ANOTHER salesperson. Growth CAPEX isn’t required to keep your business afloat. It’s used to grow the business.

One important consideration is that growth CAPEX may come with additional maintenance CAPEX. Frontier’s initial acquisition of assets was a form of growth CAPEX, but they neglected the future maintenance CAPEX required. Do you know what percentage of your expenditures are truly growth CAPEX? Are you reinvesting or simply getting by?

Depreciation Schedules

Don’t be mistaken. If you have meaningful depreciation on your income statement, it shows that assets will need to be replaced, but your annual depreciation non-cash expense may not truly represent the FUTURE cost of replacing your assets.

For instance, let’s say you buy a new truck that your CPA says will depreciate “straight-line” for 10 years. If you bought the truck for $75,000, you’ll have $7,500 of depreciation each year. Does that mean that in 10 years you’ll need to buy a new truck for $75,000? Not necessarily, for three reasons.

1. Your truck may last longer than 10 years. Maybe it’s not in the perfect shape and has high mileage, but perhaps its useful life is actually 15-20 years. It’s possible your depreciation schedule overstates your asset replacement needs. However, it’s important to be conservative since older assets require more maintenance.

2. Your truck surpasses its 10-year, 100,000 mile warranty in year 7 and breaks down. It’s possible your depreciation schedule understates your asset replacement needs.

3. We live in an inflationary world. Even if you saved the $7,500 every year for 10 years to replace your new truck, chances are, it’s going to cost $100,000 or more now. Just look at vehicle prices 10 years ago.

Ultimately, while there are IRS rules on depreciation, your accountant is going to be the one who determines your depreciation schedule. As a business owner, it may be wise to double check these to help him/her better estimate the depreciation schedule. They probably aren’t as familiar with Bubba “Crash” Thompson’s driving habits.

Using Debt to Buy Depreciating Assets

Debt, especially in our inflationary world can be a powerful tool if managed carefully. However, does it really make sense to buy assets that depreciate 5% off the lot, and potentially another 10-20% each year thereafter with debt? Does it make sense to pay banks interest to use THEIR money to simply keep your business afloat?

If you put down $15,000 on your $75,000 truck and finance the remaining $60,000 at 6% for 72-months, you will have paid $50,797.44 after 3 years. Will your truck even be worth that? Are you confident Bubba will check his mirrors now? I mean… it’s not HIS truck… Plus, you still have another $35,797.44 to pay over the next 3 years.

Congrats! After 6 years, you’ll have finally paid off your $75,000 truck with $86,594.88. But now you have no money left over to buy the next truck. Will the bank lend you $100,000 this time? Will you still get 6%? Will other trucks need to be replaced too?

This is the problem that Frontier found itself in. They acquired a massive amount of depreciating assets with debt. Those debt obligations drained the company’s cash flow annually, which resulted in cost cutting to simply maintain short-term, on-paper profitability. In order to keep shareholders happy, they paid out dividends. Each year, banks charged Frontier more and more to borrow, sensing potential bankruptcy.

Debt should be used selectively for true, cash-flowing investments — not assets that become worth LESS each year and cost the business more in maintenance.

Sinking Fund

The time to plan for depreciating assets is now. Not in two years when we’re in a recession and banks are cutting back on lending. Not when Bubba crushes the F-250s radiator again with the forklift. But now. This is NOT optional.

The best way to prepare for maintenance CAPEX is by starting a sinking fund. These are not growth opportunities, and therefore, we don’t want to be reliant on banks. They can simply say “no.” Before we take that next vacation or build that new garage at home, we need to make sure we have enough saved to keep the business afloat.

We need four things with our sinking fund:

1. Growth. We need to keep up with inflation over time. Replacement costs always go higher. If we’re wrong, then it’s a great problem to have. We’ll just have more money for growth CAPEX.

2. Downside protection. Would you gamble your employee’s payroll in the stock market? We wouldn’t say, “Sorry guys, I’m proud of our record 17 days without accident after Bubba’s departure, but the market is down. I can’t make payroll.” Maintenance CAPEX is required, and therefore, this capital needs to be safe.

3. Access. CDs offer decent growth and are generally FDIC insured. However, they also require you to lock up your capital for months at a time. We don’t know when these expenses may come up, so we need access immediately.

4. Efficiency. Wouldn’t it be nice to have our own permanent source of capital that compounds guaranteed and tax-free?

This is where Infinite Banking comes in. Instead of praying the bank gives us money in the future, and instead of that 0.01% APR we get in our checking account, we buy a properly-structured, dividend paying whole life insurance policy.

We structure this to accumulate early cash value (way different from traditional whole life insurance), which gives us an asset that has zero contractual downside regardless of what the market does. It offers guaranteed growth plus dividends. And we can access our money tax-free by borrowing AGAINST our cash value, keeping our cash value compounding permanently.

Save money today. Borrow against cash value when you need to replace assets. Repay policy loans (100% principal reduction) to continue saving in the future, which frees up your available cash value to use again and again. Meanwhile, your cash value is compounding tax-free until the day you die.

Unlike bank debt, you’re not collateralizing a depreciating asset. You’re collateralizing your cash value which CANNOT decline. You’re building an asset, temporarily borrowing against it at very attractive rates, and paying it back when you need to save more.

Plus, the insurance company doesn’t even care if you pay it back because they already owe you a much larger death benefit one day. Unlike term insurance, it’s not a matter of IF you die, but WHEN.

As your capital continues compounding over the years, you’ll eventually have more capital available to use. This isn’t a bank loan. You can use it for whatever you want, no questions asked. Growth CAPEX, a vacation, a new home, retirement, or your child’s education. Plus, you secure a sizeable death benefit that can be paid out to your family.

Getting Started

The best place to start is by looking at all of your larger assets that will need to be replaced. Think trucks and equipment, not tape measures. Write them down, estimate how long you can use them before they need to be replaced. Discuss this with your accountant if there are major differences. Then, estimate the cost of replacing those assets in the future. That should give you an annual amount to start saving each year.

When you have your numbers ready to build your sinking fund that comes with strong growth, downside protection, guaranteed access, and capital efficiency, book a call here. If you’re having trouble estimating replacement costs, we’d be glad to help.

Remember, ignoring depreciation is like letting your capital sit on death row — it’s losing value every day, and when it’s time to replace it, the shock is brutal.