Understanding depreciation and amortization: The lifespan of your dental equipment and investments.

Managing the financial health of your dental practice goes beyond simply tracking revenue and expenses. To gain a true understanding of your practice’s long-term viability, it’s essential to grasp some key accounting concepts. Two of the most important yet often misunderstood topics are depreciation and amortization. While these terms might sound complex, they play a crucial role in understanding your practice’s financial health.

Let’s start with depreciation. Depreciation accounts for the decrease in value of your tangible assets over time. Think about your dental equipment or office space — they wear down with daily use, and depreciation helps assign a monetary value to that wear and tear. This means that instead of taking on a large expense all at once, the cost is spread out over the useful life of the asset, reflecting its gradual loss in value.

On the other hand, amortization applies to intangible assets. For a dental practice, this could include things like software licenses, loan origination fees, or even goodwill from acquiring another practice. Rather than accounting for these costs all at once, amortization spreads them out over a set period, aligning the expense with the benefits these assets provide to your practice over time.

So, how do these concepts impact your financial statements?

First, on the balance sheet, depreciation and amortization lower the value of assets over time. The original cost of your equipment or intangible assets gradually shifts to an “accumulated depreciation” or “amortization” account, reducing the asset’s book value and ultimately affecting your total assets and equity.

Next, on the income statement — also known as a profit & loss statement — depreciation and amortization show up as expenses. These are deducted from your revenue to calculate your net income or earnings before interest and taxes. These expenses reduce your net income, which in turn can lead to lower income taxes.

Finally, there’s the cash flow statement. Depreciation and amortization are non-cash expenses, which means they don’t immediately impact your practice’s cash flow. But, because they reduce your taxable income, they affect the amount of taxes you’ll owe, and that can impact your overall cash situation.

When you apply for a loan, banks review your tax returns, balance sheet, and income statement. Using these documents, they essentially build a cash flow statement to determine your ability to cover both practice expenses and the loan you’re applying for.

Depreciation and amortization from your tax returns or profit & loss statement are added back in to calculate cash flow, as they don’t represent immediate cash outlays. The cash generated by your practice is a key indicator that lenders use to evaluate its profitability and overall financial health.

And before lenders can approve a loan, they’re required by regulation to verify your ability to cover existing obligations, as well as the new loan, while still generating enough cash to invest in the future, pay yourself, and build reserves.

Depreciation and amortization may seem like accounting jargon, but they’re necessary for understanding the full picture of your practice’s financial health. By knowing how these concepts work, you can better plan for the future, whether it’s budgeting for new equipment or preparing for tax season. If you’re looking for more specific advice on how depreciation and amortization affect your practice, be sure to consult with your CPA. And if you have questions about managing your practice’s finances, Commerce Bank opens in a new window is here to help.