Instructor Blog - Credit College - Commercial Real Estate

Q: In calculating Business Profit and analyzing a company’s ability to generate profits adequate to service debt, wouldn't we be adding back depreciation expense? It seems that adding back depreciation, even if misstated, would eliminate the distortion created by what seems to be Sequoia Properties error in reporting depreciation expense.

A: Business Profit is intended to define profits generated after all recurring expenses have been deducted and after the impact of one-time-only income or expense has accordingly been eliminated. The purpose in doing so is to be able to work with the “purest” statement of recurring profits in considering the first indicator of business success – the ability to generate profits adequate to service debt.  

Depreciation expense is not added back in calculating Business Profit because it is a recurring expense. Distributions and loans to owners of pass-through entities are deducted in calculating Business Profit because they, in essence, represent recurring taxes payable on the earnings of the company and compensation to owners if the distributions and loans exceed the taxes due.  

You are absolutely right in recognizing that adding back depreciation expense, or any other expense, would eliminate the possibility of misstated profits because of incorrectly calculated depreciation expense. We saw that dynamic unfold in subsequent steps we took in analyzing Sequoia Properties.