I do not have an accounting background so please excuse the point blankness of my question. I'm writing a business plan and saw that several sample plans include depreciation in their financial models. Could you please help me understand why we have to consider depreciation?
Business Plan Accounting Forecasting
Depreciation is a business expense. It reduces the value of your assets. A simple analogy makes this clear.
You buy a brand new business computer for $1,000. Then 2 years later, you decide to upgrade to a new computer, and you spend $1,000 again. Now you have your old computer sitting around doing nothing, so you decide to sell it on eBay, and you get $50 for it. This means your old computer depreciated by $950. That is your business expense.Different assets depreciate at different rates. Computers tend to depreciate very quickly. Cars relatively quickly. And real estate, very slowly (or it often appreciates).
Why this matters for a business plan, is because it affects how much your business is worth over time. If you don't count depreciation in the computer example above, after the two years, your business would be worth $950 more on paper than it really is.
While for many purchases (such as a computer, or a hammer), and in some situations, you may be able to count the entire purchase price as a business expense and not worry about depreciation*, for other types of expense (such as an automobile, real estate, or large equipment), you will not be allowed to do this (depending on which country you live in and local tax laws, etc).
But even when you are allowed to ignore depreciation, it's often to your advantage (for taxes) to depreciate your assets. Talk to your accountant or CPA for your specific situation.
* From an IRS standpoint, at least in some cases, I believe it's still considered depreciation, you just count the depreciation to all have happened during the same year as the purchase.
When completing your cash flows business model make sure to record properly the actual time of cash expenditure. Since depreciation is a non-cash expense and does not reflect when you actually when you spent the cash your cash flow must add back the depreciation.