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Finance & Accounting

What Is Depreciation?

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Depreciation is a calculation used to reduce the value of a fixed asset over a period of multiple years. Many small-business owners find this concept confusing because depreciation does not match cash flow. Instead, it is a calculation made and an entry recorded into the bookkeeping on a recurring basis.

Fixed assets lose their usefulness and value over time. This loss usually doesn’t coincide with when the purchase is made, even if the purchase is made over time by making installment payments. Like accrual basis accounting, depreciation matches expenses to a given time period, but it isn’t strictly an accrual basis concept. This calculation will appear on both cash basis and accrual basis financial statements.

Depreciation formula

The different depreciation formulas are:

Straight-line depreciation formula:

(Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense

Units of production depreciation formula:

(Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense

Double declining balance depreciation formula:

100% / Life of asset = Depreciation rate

Sum of the years’ digits depreciation formula:

(Remaining life of the asset / Sum of the years digits) x (Cost of asset – Scrap value of asset) = Depreciation expense

With these formulas in mind, let’s take a closer look at each depreciation method and when you might want to use each.

Depreciation methods and examples

There are four common methods of depreciation used in accounting. These accounting methods differ from the depreciation schedules used for taxes. They are still important to know in order to determine how to make this calculation from a managerial perspective.

1. Straight-line depreciation

The most common method is called straight-line depreciation. It is also the simplest method. With straight-line depreciation, you subtract the estimated salvage or scrap value of the asset at the end of its useful life from the cost of the asset, then divide that value by the useful life of the asset. In other words:

(Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense

Example: Let’s say you purchase a piece of equipment for $260,000. You anticipate using the equipment for eight years, and you anticipate the scrap value will be $20,000. The calculation for depreciation of the vehicle under the straight-line method would be:

($260,000 – $20,000) / 8 = $30,000

In order to not skew your end-of-year financial statements, you want to make the depreciation entry each month:

$30,000 / 12 months = $2,500/month

Each month of the year, you would make the following journal entry:

Debit: Depreciation expense $2,500

Credit: Accumulated depreciation: Equipment $2,500

This will reduce your net income by $2,500 each month, and it will also offset the value of the asset on your balance sheet by $2,500 each month.

Note that you’re not crediting the actual asset account on the balance sheet, but a separate account called “accumulated depreciation.” The accumulated depreciation account will have a negative balance, which offsets the value of the asset without changing it on the balance sheet. You will often see these accounts as sub-accounts of the different types of fixed asset accounts on the balance sheet.

2. Units of production depreciation

The units of production depreciation method is similar to the straight-line method in that it is simple to calculate. Units of production depreciation is most often used for equipment that is expected to produce a certain number of items before it is no longer useful.

The formula for units of production depreciation is:

(Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense

Example: Let’s say the equipment you purchased in the example for straight-line depreciation is a machine you will use to manufacture whatsits. The machine is expected to produce 120,000 whatsits before it is no longer useful. You pay $260,000 for the machine, and the scrap value is estimated to be $20,000.

Each year, you will determine how many units the machine produces. Let’s assume in year one the machine produces 2,000 whatsits, in year two it produces 4,000 and in year three it produces 8,000:

Year 1: (2,000 / 120,000) x ($260,000 – $20,000) = $4,000

Year 2: (4,000 / 120,000) x ($260,000 – $20,000) = $8,000

Year 3: (8,000 / 120,000) x ($260,000 – $20,000) = $16,000

You will continue this calculation yearly until the machine reaches its production capacity of 120,000 whatsits.

As with the straight-line method, you will want to divide the depreciation expense by 12 and record it each month so you don’t skew your financials in the last month of the fiscal year.

3. Double declining balance depreciation

Double declining balance depreciation is an accelerated depreciation method. Accelerated methods are used when you are dealing with assets that are more productive in their early years. The double declining balance method is often used for equipment when the units of production method is not used.

The calculations for accelerated methods are a bit more complex than those for straight-line or units of production methods, and so usually business owners using accelerated methods will set up a depreciation schedule — a table that shows the depreciation expense for each year of the asset’s life — so they only have to do the calculations once.

Example: Let’s say you don’t know how many units your whatsit manufacturing machine can produce, but you know it’s likely to last eight years. First, you’ll need to calculate the rate of depreciation:

100% / Life of asset = Depreciation rate

100% / 8 = 12.5%

You’ll multiply the depreciation rate above by two because you are doubling the rate of depreciation:

12.5% x 2 = 25%

Once you have your depreciation rate, will multiply that rate by the beginning value of the asset to get the depreciation expense for the first year:

Beginning value of asset x Depreciation rate = Depreciation expense

$260,000 x 25% = $65,000

Finally, you need to calculate the value of the asset at the end of year one:

$260,000 (beginning value of asset) – $65,000 (depreciation expense) = $195,000

The depreciation calculation for year two follows the same formula, except now your beginning asset value is $195,000:

$195,000 x 25% = $48,750

And the ending value for year two is calculated:

$195,000 – $48,750 = $146,250

You will continue with these calculations until you reach the scrap value of the asset.

4. Sum of the years’ digits depreciation

Like double declining depreciation, sum of the years’ digits depreciation is an accelerated method. The formula is:

(Remaining life of the asset / Sum of the years digits) x (Cost of asset – Scrap value of asset)* = Depreciation expense

*The second part of this equation is the depreciation base

Example: Let’s stick with our whatsit machine for this example. First, let’s calculate our depreciation base:

Cost of asset – Scrap value of asset = Depreciation base

$260,000 – $20,000 = $240,000

Next, you’ll need to determine the “remaining life of the asset/sum of the years’ digits” piece of the calculation. The remaining life is just as it sounds: It’s the remaining life of the asset. For this example, in year one the remaining life will be eight years, in year two it will be seven years, and so on. The tricky bit of this equation is the “sum of the years’ digits” piece.

Here’s how the calculation would look in year one:

8 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.222

And now you multiply this factor by the depreciation base:

0.222 x $240,000 = $53,280

Our year one depreciation expense is $53,280. In year two, our calculation would look like this:

7 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.194

0.194 x $240,000 = $46,560

And our year three calculation would be:

6 / (8+7+6+5+4+3+2+1) = 0.167

0.167 x $240,000 = $40,080

You will continue with these calculations until there is no remaining life of the asset and you reach the asset’s scrap value.

Depreciation for taxes

The four methods above are used for managerial and business valuation purposes. And although it’s important to understand these methods, many small-business owners will only record depreciation as it is calculated by their accountants for the tax return. This ensures the balance sheet matches the tax return, which in turn makes it easier to validate the accuracy of the financial statements.

Tax depreciation is different from depreciation recorded for managerial purposes. Tax depreciation follows a system called MACRS, which stands for modified accelerated cost recovery system. MACRS is a form of accelerated depreciation, and the IRS publishes tables for each type of property. You can learn more about MACRS depreciation and review the tables on the IRS’s website.

Using depreciation to manage cash requirements

One often-overlooked benefit of properly recognizing depreciation in your financial statements is that you can use this calculation to plan for and manage your business’s cash requirements. This is especially helpful if you want your business to fund the acquisition of future assets rather than taking out a loan to acquire them.

Let’s look back at our very first example. Because we’ve taken the time to determine the useful life of our equipment for depreciation purposes, we can make an educated assumption that the business will need to purchase a new piece of equipment within the next eight years. The earlier we can start planning for that purchase — perhaps by setting aside $2,500 per month in a business savings account — the easier it will be to fund the replacement of the equipment when the time comes.

A version of this article was first published on Fundera, a subsidiary of NerdWallet

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Finance & Accounting

Business Loan vs. Line of Credit: Which Is Right for You?

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Business loans and business lines of credit are different forms of business financing. With a business loan, you’ll receive a lump sum of money and pay it back over time. A line of credit is a pool of money that you can keep dipping into, up to a limit.

In general, business loans are the better choice when you need a significant amount of financing for a major purchase or expansion. Business lines of credit are better suited for evening out gaps in your cash flow or floating your finances through an emergency.

What is a business loan?

A business loan is a lump sum that you receive from a small-business lender and then pay back over time with interest. Business loans are best when you need financing for a specific project, investment or acquisition that will help grow your business.

  • You can usually borrow more with a loan than you can with a line of credit.

  • In most cases, you’ll receive all your loan funds in one upfront payment.

  • You’ll typically need to secure a loan with collateral like real estate, inventory or cash savings.

  • Some types of business loans can only be used for specific purposes — for instance, if you take out an equipment loan, you can’t use it to pay your employees during a lean month.

What is a business line of credit?

A business line of credit can help you get access to working capital whenever you need it. Lines of credit work in a similar way to credit cards — you can borrow as much money as you need up to your credit limit, and then pay it back over time. Lines of credit are best for businesses who want ongoing access to financing to even out their cash flow or to tap in emergencies.

  • Lines of credit can be used for any business expense.

  • Some lines of credit are unsecured, meaning you won’t have to provide physical collateral.

  • Lines of credit tend to be smaller than business loans.

Business line of credit vs. loan: How to choose

In general, business loans are best suited for financing specific projects. Lines of credit are more like business credit cards, making them useful if you want to tap into working capital on an as-needed basis.

The best choice for your business depends on how much financing you need, what you want to use it for and what you can qualify for.

Business loan

Business line of credit

How much financing do you need?

Varies widely, but loans usually offer more financing than lines of credit.

Varies widely, but lines of credit are usually smaller than loans.

What do you need financing for?

A specific purpose. In your loan application, you’ll have to explain what you plan to do with your loan funds.

Can be used for any purpose.

How do repayments work?

Installment credit — you receive a lump sum and pay it back in regular installments over time.

Revolving credit — you can carry a balance that accrues interest and pay it back as you’re able, then borrow more.

Do you have collateral?

Almost always requires collateral.

Unsecured lines of credit do not require collateral.

What product can you qualify for?

Tends to require good credit, multiple years in business and more annual revenue.

Usually easier to qualify for than business loans.

Where to get a business loan or line of credit

Many banks and online lenders offer both business loans and business lines of credit.

Bank business loans and lines of credit

In general, bank loans are the hardest to qualify for, but they also tend to offer the lowest interest rates and most favorable terms. If you have multiple years in business and good or excellent credit, seek bank financing.

National banks offering business loans and lines of credit include:

  • Bank of America: Business loans and lines of credit. Bank of America offers a wide variety of business loan products with competitive interest rates, but they can be difficult to qualify for, and the application process requires a meeting with a lending specialist. Read NerdWallet’s Bank of America business loan review.

  • Chase: Business loans and lines of credit. Chase offers small loans — business loans of as little as $5,000 and lines of credit with limits as low as $10,000 — which can be easier to qualify for than large loans and help you build business credit.

  • Wells Fargo: Business loans and lines of credit. You can get a secured or unsecured line of credit from Wells Fargo. The bank has discontinued many of its term loan products but still offers SBA loans.

Online business loans and lines of credit

Online lenders can be a good resource for newer companies or business owners with fair or bad credit. They also tend to fund loans more quickly than banks can, sometimes within a day. But their interest rates tend to be higher than those offered by banks.

Online lenders offering business loans and lines of credit include:

  • OnDeck: Business loans and lines of credit. Business owners with fair to good credit may be able to qualify for OnDeck loan products, but their interest rates can be high. Read NerdWallet’s OnDeck review.

  • Kabbage: Lines of credit only. Kabbage lines of credit are a good fit for business owners with fair credit who want fast access to capital, but their fee structure is complex. Read NerdWallet’s Kabbage review.

  • Funding Circle: Business loans only. Funding Circle tends to offer lower interest rates than other online lenders, but loans are more difficult to qualify for and take slightly longer to fund. Read NerdWallet’s Funding Circle review.

  • Bluevine: Lines of credit only. Bluevine lines of credit are available to business owners with as little as six months in business, but you may need to make frequent repayments. Read NerdWallet’s Bluevine review.

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5 financial tips for millennial business owners

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Money matters

This content should not be construed as financial advice. Always consult a financial professional regarding your specific financial situation.

In 2017, I wrote an article about financial tips for millennial business owners. Five years later and two years into the ongoing COVID-19 pandemic, I was surprised to find that most of the original advice still holds true today. However, some changes are worth noting that will better empower millennials to succeed personally and professionally with their finances.

Five financial tips for millennial business owners

Here are five things today’s millennial business owners should consider. We will look at each tip in more detail.

  1. Pay down and pay off outstanding debt.
  2. Work alongside a financial adviser.
  3. Observe the money moves of Gen Z.
  4. Build an emergency fund.
  5. Establish Plan B.

1. Pay down and pay off outstanding debt

My original article emphasized the importance of getting out of student loan debt. I mentioned suggestions for managing that debt, like lowering student loan bills through better repayment or refinancing plans and making loan payments on time. Hopefully, doing these things would make it easier for millennial business owners to financially plan to start a business.

However, according to Bank of America’s Better Money Habits Millennial Report, student loans now only account for 25% of millennials’ debt. The Winter 2020 report examines the precarious balancing act that millennials have with outstanding debt. And this debt is no longer limited to student loans.

The reason? Millennials are no longer twentysomethings. Millennials began turning 40 in 2021. The report shares the various types of debt that millennials carry in middle age, including auto loans (40%), credit card debt (37%) and mortgages (36%). Each makes up a higher percentage of debt than student loans.

Further, the report addresses the worries that millennials have surrounding their debt. Those surveyed say that having debt keeps them from reaching professional and personal milestones. Millennials today feel like they can’t or can’t yet fulfill the following goals:

  • Buy a first or nicer home (42%).
  • Save for the future (40%).
  • Welcome children or grow their family (21%).
  • Get married (21%).
  • Start their own business (19%).

Despite these grim percentages, millennials are not giving up.

The COVID-19 pandemic has impacted the American workforce with the Great Resignation. Millions of workers are quitting their jobs, with a January 2022 study from Cengage Group citing 38 million workers who resigned in 2021.

Quitting does not mean millennials do not plan to work again. Instead, they are taking back their power. Ninety-one percent quit their jobs to make more money, 82% are reconsidering priorities amid the pandemic and 81% wish to pursue another passion or career path and are reskilling appropriately.

For many millennial business owners, relying on traditional financial tips like refinancing, budgeting, and making on-time payments isn’t enough to get entirely out of debt. Resigning from a job where you feel stagnant, or experience stagnating wages is a critically important next step for paying off debt and revitalizing your career trajectory.

2. Work alongside a financial adviser

Couple holding hands with a contract and pen on table in front of them

No matter your stage in running a business, every small business benefits from working with a reliable financial adviser.

What can a financial adviser do for you? These advisers assist millennial business owners in making sound financial decisions. An adviser is well-versed in financial literacy and understands planning in certain and uncertain times of economic stability. Many also work with niche-based entrepreneurs, like those within the FIRE (financial independence, retire early) and HENRY (high earner, not rich yet) communities.

Best of all, millennials can even work alongside a millennial financial adviser if they choose.

If you’re currently on the hunt for one, check out this roundup on Business Insider of the 23 most influential financial advisers for millennials.

3. Observe the money moves of Gen Z

Millennials and Gen Z “allegedly” don’t like one another very much. Something about a TikTok dance? I digress. Millennials can learn from individuals at all stages of entrepreneurship, including the class of creators that makes up Gen Z.

How exactly does watching the entrepreneurial moves of Gen Z translate to financial advice?

Gen Z came up in a world where many cheaper tools are at their disposal. They are natural social natives that utilize digital platforms to build their brand.

Watch which tools they use to build their business and how they save money through using them. A good example is observing the platforms they use, like Square to accept payments and Etsy for creating an ecommerce presence. These tools are cost-effective and allow Gen Z to focus on their business. Take a few notes if you haven’t started already, millennials.

4. Build an emergency fund

If business owners have learned anything from the COVID-19 pandemic, it is the importance of having and maintaining an emergency fund.

Emergency funds are exactly what they sound like: three to six months’ worth of expenses set aside to be used in the event of an emergency. This emergency can be anything from a pandemic to a natural disaster. Having an emergency fund means having the ability to cover an unexpected expense without taking out a loan or using a credit card with a high-interest rate.

Three additional pro tips I have for building an emergency fund are below:

  1. If you withdraw a certain amount from your emergency fund, remember to pay it back. Ideally, do this as quickly as possible.
  2. Use this fund only in the event of an actual emergency.
  3. Add to an emergency fund regularly. Treat it as you might a retirement fund. Strategize with the help of a financial adviser as to what this fund’s maximum contributions might look like every year. Then, add to the fund accordingly. Too often, emergency funds are viewed through a one-time lens. Business owners should set up the fund in a safe space like a high-yield savings account and keep contributing funds to it over time.

5. Establish Plan B

Plan B was in the original version of this article, and I’m using it to conclude this updated list of financial tips for millennial business owners.

Having a Plan B is essentially creating a backup plan for your life. The phrase is often used negatively as if to say that because a particular business venture didn’t work out, you can’t be an entrepreneur again. That’s not true. Having a Plan B means having a safety net for every good and bad “what if?” scenario.

If something doesn’t work out now, you have options, and Plan B will help you find and pursue them.

This content should not be construed as financial advice. Always consult a financial professional regarding your specific financial situation.



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Banking

Are Small-Business Loans Installment or Revolving?

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A small-business loan provides funds to purchase supplies, expand your business and more. This type of funding can be either installment or revolving. Reviewing the credit terms of your loan offer will help you determine whether you’re being offered an installment loan or revolving credit.

Both types of loans can be found in the Small Business Administration, or SBA, loan program and at banks, credit unions and online lenders. While each can provide much-needed funding for your business, there are some key differences to keep in mind.

Installment loans vs. revolving credit

Installment loans provide a lump sum of money

An installment loan is a credit agreement where the borrower receives a specific amount of money at one time and then repays the lender a set amount at regular intervals over a fixed period of time. Typically, each payment includes a portion for interest and another amount to pay down the principal balance.

Business term loan is another common name for this type of loan. After the loan is paid off, the borrower typically must apply for a new loan if additional funds are needed.

Revolving credit provides flexible funds

A revolving loan is a credit agreement where the borrower can withdraw money as needed up to a preset limit and then repays the lender a portion of the balance at regular intervals. Each payment is based on the current balance, interest charges and applicable fees, if any. You pay interest only on the funds that you use — not the maximum limit.

A business line of credit is a common type of revolving credit. Revolving credit gives the borrower flexibility in determining when to withdraw money and how much. As long as the credit balance remains within the preset limit and you continue to make timely payments, you can continue to draw from the line again and again.

Differences between installment loans and revolving credit

The terms of a loan can vary depending on the type of loan, lender and your business’s credentials. Your loan may be a unique combination of terms. However, the following are some common differences between installment and revolving loan programs.

Installment loan

Revolving credit

Loan amount

Fixed amount.

Maximum limit.

Withdraw as needed.

Payment amount

Fixed amount.

Minimum amount based on balance and interest with option to pay more.

Interest calculation

Based on loan amount.

Based on current balance, not maximum loan limit.

Ability to renew

Not renewable, typically.

Renewable, typically.

  • SBA loans.

  • Business term loans.

  • Commercial real estate loans.

  • Equipment loans.

  • Microloans.

  • SBA lines of credit.

  • Business lines of credit.

  • Business credit cards.

When to use an installment loan

Set loan amount is needed

If you’re confident in the loan amount you need, then an installment loan may be the right fit, especially if you need the money in a lump sum. For example, if you’re using the funds to make a one-time purchase, you’ll likely want an installment loan.

Long-term financing needs

Some term loans can offer you more time for repayment when compared with revolving credit. When you stretch your payments out over a longer period of time, it can mean a lower monthly payment. However, that trade-off typically means you’ll pay more in interest costs over the life of the loan.

Larger funding needs

If you’re looking to purchase property, equipment or other large-ticket items, there are a number of installment loans that can be used for this purpose. Revolving credit limits are often less than term loan maximums.

Preference for predictable payments

With a set monthly payment amount, it can be easier to budget for an installment loan compared with a revolving loan, where the payment varies depending on how much of the credit line you use.

When to use a revolving loan

Short-term financing needs

Revolving credit can be good to handle short-term cash shortages or to cover unexpected expenses. Some businesses use lines of credit as an emergency fund of sorts since they’ll pay interest only on the funds they use.

Fluctuations in cash flow

Businesses that experience major fluctuations in their cash flows may benefit from revolving credit. For example, seasonal businesses that don’t have consistent revenue throughout the year can use lines of credit to cover operational costs during their slow season.

Preference for flexible loan amount and payments

If you don’t know exactly how much money you need, then revolving credit will give you the option to qualify for a maximum amount but only withdraw funds as you need them. This way, you’ll pay interest only on the current amount owed.

Compare small-business loans

To see and compare loan options, check out NerdWallet’s list of best small-business loans. Our recommendations are based on the lender’s market scope and track record and on the needs of business owners, as well as rates and other factors, so you can make the right financing decision.

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