Wealth, Liquidity, and Depreciation

Incorporating a business and forming a partnership are two ways to help grow wealth. However, corporations have obligations to shareholders to provide wealth for the shareholders, whereas this is not the primary concern of a successful partnership. In order to maximize wealth, a corporation is different from a partnership in a few keyways. 

First, shareholders are not liable for the debt of a corporation, whereas the principal owners in a partnership are. This maximizes wealth for the shareholders in a corporation by limiting their exposure to negative cash flow and debt. Corporations are also generally able to raise more money than a partnership. This allows for easier and quicker growth and expansion, enabling shareholders to enjoy more wealth from the increased revenue.  Finally, corporations maximize wealth through raising the market value of the company. Unlike measuring just profitability, the market value of a corporation is based on cash flow and risk, and the market value for a corporation is more important than for a partnership. 

Because of the importance of liquidity, especially to retailers, business owners must understand the liquidity opportunities and challenges facing their business. By looking at the current and quick ratios, business owners can assess how well they are managing their assets. The current ratio is a formula measuring current liquidity by dividing current assets by current liabilities. A “good” ratio varies by industry, but a ration between 1 and 3 means a company probably has enough money to cover operating costs and is not hoarding money (Motley Fool Staff 2008). 

The quick ratio is like the current ratio but considers inventory. This is important for retailers because much of their assets might be tied up with inventory, but inventory does not always retain its worth, and therefore is not a good cash equivalent.  To determine the quick ratio, one subtracts inventory from current assets and divides by current liability. A quick ratio greater than 1.0 typically means a business is sustainable (Motley Fool Staff 2008).

Depreciation is a non-cash charge measured in a number of ways. Straight-line depreciation is very common because it is simple. With straight-line depreciation, one deducts the same amount of depreciation of the property over its lifetime (Investopedia). This means the depreciation is consistent and recurring, therefore easy to manage. Another way to measure depreciation is subtract the salvage or resale value of property from the initial cost and divide that number by the units produced by the property (Investopedia). The units produced can also be replaced by the number of hours the property used in order to calculate depreciation for property that is not production-based.

Other types of depreciation allow for a faster initial write off if assets and is useful for property that might become obsolete or not be used through its full lifespan. One common method of this type of depreciation is the sum-of-year method. In it, companies use the time they expected to use the property and deduct the largest fractions of depreciation up front so that property is devalued less over time (Investopedia). For example, property might be devalued by 30% in the first year but only 20% in the third year. Another common method of accelerated depreciation is the double-decline-balance method. This aggressive method of depreciation allows the property owner to set a percentage rate by which the property is depreciated each year up to its salvage or resale value.

Depreciation as a non-cash charge does not directly affect cash flow, though it can affect the balance sheet and the opinions of shareholders' financial investments. However, calculating depreciation means giving property an end-of-life date, at which time the asset will have to be replaced. This means business operators will have to manage cash flow accordingly. Depreciation affects the net profit of a business because it erodes the value of property. A business full of machinery will be worth less each year because of depreciation.

References

Capital cost allowance and depreciation—types of depreciation. (n.d.). In Investopedia. Retrieved from http://www.investopedia.com/walkthrough/corporate-finance/2/depreciation/types–depreciation.aspx

Motley Fool Staff. (2008, May 23). How to read a balance sheet: current and quick ratios. The Motley Fool. Retrieved from http://www.fool.com/investing/beginning/how-to-value-stocks-how-to-read-a-balance-sheet-cu.aspx