Depreciation Policy

Depreciation policy also exerts an influence on the quantum of working capital. Depreciation charges do not involve any cash outflows, The effect of depreciation policy on working capital is, therefore, indirect. In the first place, depreciation effects the tax liability and retention of profits. Depreciation is allowable expenditure in calculating net profits, enhanced rates of depreciation lower the profits and, therefore, the tax liability and, thus, more cash profits. Higher depreciation also means lower disposable profits and, therefore, a smaller dividend payment. Thus, cash is preserved, in the second place, the selection of the method of depreciation has important financial implications. If current capital expenditure falls short of the depreciation provision, the working capital position is strengthened and there may be no need for short term borrowing. If, on the other hand, the current capital expenditure exceeds the depreciation provision, either outside borrowing will have to be resorted to or a restriction on dividend payment coupled with retention of profits will have to be adopted to prevent the working capital position from adversely affected. It is in these ways that depreciation policy is relevant to the planning of working capital.

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