Practical Guide to Modeling Depreciation in Startup Financial Forecasts and Tax Planning

Why Including Depreciation in Startup Financial Projections is Non-Negotiable

Handling large equipment or office setup costs in your financial projections can feel counterintuitive. You spend a significant amount of cash upfront, but that single transaction doesn't accurately reflect the asset's long-term value to your business. This disconnect between cash spending and value usage often leads to overstated margins and misleading runway forecasts, creating difficult questions in board meetings and investor updates. Learning how to include depreciation in startup financial projections is not just an accounting exercise; it’s a critical step toward building a credible, accurate financial model. By properly accounting for fixed assets, you gain a clearer view of your operational profitability, unlock significant tax advantages, and strengthen the financial foundation of your startup from pre-seed to Series B. For a deeper dive, see the capex and intangibles hub.

Understanding the Core Concepts: Capex, Depreciation, and Profitability

A common question from founders is: “I spent $10k on laptops. Did I lose $10k in profit this month?” The answer is no, and understanding why is fundamental to financial modeling. That $10,000 is a Capital Expenditure (Capex), which is the cash you spend on acquiring a physical asset that will be used for more than one year. On your cash flow statement, you’ll see a $10,000 cash outflow. But on your Profit & Loss (P&L) statement, which measures profitability over a period, it's a different story.

Instead of recognizing the full cost at once, you spread it over the asset’s “useful life” through a process called depreciation. Depreciation is the non-cash expense that represents the asset’s value being systematically used up over time. The laptops become Fixed Assets on your Balance Sheet. Each month, a portion of their cost is recorded as a depreciation expense on the P&L, reducing your reported profit without any actual cash leaving your bank account for that specific entry.

The critical distinction is this: Capex is a one-time cash event, while depreciation is a recurring accounting entry that reflects an asset's declining value and its contribution to generating revenue over time. Getting this right is central to startup accounting for fixed assets and presenting a true picture of your company's health.

Step 1: How to Model Depreciation Using a Waterfall Schedule

How do you actually calculate depreciation without complex software? For most startups, the answer lies in a straightforward spreadsheet and the straight-line depreciation method. This approach is preferred for internal management reporting because it evenly allocates an asset's cost over its lifespan, providing a consistent and predictable view of its impact on profitability. The formula is simple: (Asset Cost - Salvage Value) / Useful Life. For early-stage modeling, the Salvage Value, which is the estimated resale value at the end of its life, is typically assumed to be $0 to simplify calculations.

Forecasting Asset Lifespan

To start, you need to estimate the asset's useful life. While this can vary, adhering to standard accounting practices is the most reliable approach for consistency and comparability. A good rule of thumb is that startups use 3 years for computers and other IT equipment, and 5 years for furniture, office equipment, and machinery. (Standard accounting practice) These timelines provide a realistic basis for forecasting asset lifespan in most scenarios, from a professional services firm buying laptops to a deeptech company acquiring lab equipment.

Building the Schedule: A Practical Example

Let’s walk through a synthetic example. A biotech startup buys a specialized lab analyzer for $180,000 in January. It has an estimated useful life of 5 years (or 60 months). Using the straight-line method, the monthly depreciation expense is calculated as $180,000 / 60 months = $3,000.

To manage this for multiple assets bought at different times, you build a “waterfall schedule” in your spreadsheet. Each row represents a new asset purchase, and the columns represent months. In the month of purchase, you begin recording the calculated monthly depreciation expense. As you acquire more assets, you simply add new rows. The total depreciation expense for any given month is the sum of that month’s column.

For instance, if the same biotech company buys new office furniture for $60,000 in March with a 5-year useful life ($60,000 / 60 months = $1,000/month depreciation), your schedule would evolve. The total depreciation expense would be:

• January: $3,000 (from the analyzer)
• February: $3,000 (from the analyzer)
• March: $4,000 ($3,000 from the analyzer + $1,000 from the new furniture)

This running total continues, with the expense increasing each time a new asset is purchased. This schedule becomes the single source of truth for depreciation in your entire financial model, ensuring accuracy and consistency.

Step 2: Integrating Depreciation into Your 3-Statement Financial Model

Now that you have the numbers from your waterfall schedule, where do they go? This is where you connect the dots and learn how to model depreciation across your P&L, Balance Sheet, and Cash Flow Statement, ensuring they all balance perfectly. The reality for most pre-seed to Series B startups is pragmatic: the model needs to be correct, but it also needs to be simple enough to maintain. Here’s the standard flow for your projections.

1. The Profit & Loss (P&L) Statement

Your total monthly depreciation from the waterfall schedule is recorded as an operating expense (OpEx). Under both US GAAP and UK FRS 102, it typically sits below the Cost of Goods Sold (COGS) section. Its inclusion directly reduces your key profitability metrics, such as Earnings Before Interest and Taxes (EBIT) or Operating Income. This is crucial because it gives you a more accurate picture of your operational profitability by accounting for the cost of the assets used to generate revenue during that period.

2. The Cash Flow Statement

This statement is essential for reconciling your net income (from the P&L) back to your actual cash balance. It is composed of three sections. Your initial Capex appears here first, as a cash outflow under “Cash Flow from Investing Activities” in the month of purchase. This reflects the actual cash leaving your bank.

Then, in the “Cash Flow from Operating Activities” section, you add back the total monthly depreciation expense. Why? Because you subtracted it as a non-cash expense to calculate net income on the P&L, but no cash actually left your business for that expense. This adjustment is critical for calculating your true cash burn and producing an accurate runway forecast that investors can rely on.

3. The Balance Sheet

The Balance Sheet provides a snapshot of your company’s assets, liabilities, and equity at a specific point in time. When you first purchase an asset, your Gross Fixed Assets on the asset side of the sheet increase by the purchase price. Each month thereafter, the depreciation expense from your P&L increases a contra-asset account called Accumulated Depreciation. This account is netted against Gross Fixed Assets.

The key formula here is: Net Fixed Assets = Gross Fixed Assets – Accumulated Depreciation. As a result, your Balance Sheet always reflects the asset's current book value, showing its gradual decline over its useful life. In your accounting software like QuickBooks or Xero, you can manage this by setting up fixed asset accounts and recording monthly depreciation with a standard journal entry.

Step 3: The Strategic Payoff of Proper Capex in Startup Forecasts

Why should you spend time on this level of detail? What's the return on this effort? Properly handling capex in startup forecasts delivers two major benefits: tangible tax savings and a significant increase in investor confidence.

Unlocking Powerful Tax Advantages

For internal management purposes, straight-line depreciation is best for its simplicity and consistency. For tax reporting, however, governments in both the US and UK offer powerful incentives that allow for accelerated depreciation, which can reduce your taxable income significantly in the year of purchase.

• For US Companies: Two key provisions exist. First, USA Section 179 allows businesses to expense up to $1.22 million of qualifying equipment in the year of purchase (2024). This is a direct deduction from your taxable income. Additionally, USA Bonus Depreciation allows an immediate deduction of 60% of the cost of certain new and used assets in 2024. A US-based deeptech startup buying $500,000 in R&D equipment could potentially deduct the entire amount from its taxable income in the first year, representing a massive cash-saving advantage.
• For UK Companies: The primary tool is the Annual Investment Allowance (AIA). The UK Annual Investment Allowance (AIA) allows a business to deduct the full value of a qualifying item, up to a £1 million limit, from its profits in the year of purchase. For example, an e-commerce startup in the UK spending £200,000 on new warehouse shelving and packing machines can deduct that full amount, significantly lowering its corporation tax bill for that year.

Building Credibility with Investors

Beyond the direct tax benefits, a well-structured model signals competence to investors. In practice, we see that founders who can clearly articulate the difference between their cash position and their profitability build more trust. It shows you are not overstating your gross or operating margins by ignoring the very real cost of the assets required to run the business.

It demonstrates financial discipline and a robust understanding of your own unit economics and capital requirements. When your financial model correctly incorporates depreciation, your runway projections and funding asks become far more credible, as they are grounded in sound accounting principles rather than a simple cash-in, cash-out forecast.

Practical Takeaways for Your Financial Model

Integrating depreciation into your financial model moves it from a simple cash forecast to a sophisticated tool for strategic decision-making. The goal is not accounting perfection on day one, but to build a system that accurately reflects your business's financial health and supports its growth.

Here’s a simple plan to get started:

1. Build a Simple Schedule: Start today with a waterfall schedule in a spreadsheet. Create a simple register to track each major asset, its cost, its purchase date, and its useful life. This is the foundation of your entire process.
2. Use Standard Lifespans: Don't overcomplicate it. Begin with standard useful life estimates for startups: 3 years for computers and 5 for furniture/equipment. (Standard accounting practice) You can adjust later if necessary, but consistency is key at the start.
3. Distinguish Book vs. Tax Treatment: Distinguish Book vs. Tax. Use the straight-line depreciation method for your internal P&L and forecasts to ensure consistent reporting. Then, consult with your accountant to take full advantage of accelerated methods like Section 179 (US) or AIA (UK) on your official tax returns.
4. Keep Your Tools Tidy: Maintain a clean fixed asset register in your accounting software, whether it’s QuickBooks or Xero. This makes tracking purchases, disposals, and accumulated depreciation much easier for reporting and auditing purposes.

Ultimately, a model that correctly handles depreciation provides a truer picture of your operating margins and long-term sustainability. It is a foundational element of sound financial management that pays dividends in both direct cash savings and enhanced investor confidence. To continue learning, read more in the capex and intangibles hub.

Frequently Asked Questions

Q: What is the difference between depreciation and amortization?
A: Depreciation refers to the process of allocating the cost of tangible assets (like equipment or buildings) over their useful life. Amortization is the equivalent process for intangible assets, such as patents, copyrights, or capitalized software development costs. Both are non-cash expenses that reduce taxable income.

Q: How does including depreciation in startup financial projections affect valuation?
A: Depreciation reduces your reported net income (profit). While this might seem negative, sophisticated investors look at metrics like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to assess core operational profitability. A correct model shows you understand your true costs, which builds trust and supports a more defensible valuation.

Q: Do I need to depreciate small purchases like a single monitor or keyboard?
A: Generally, no. Most companies set a "capitalization threshold," often between $500 and $2,500. Purchases below this amount are treated as a regular operating expense in the month they occur, rather than being capitalized as an asset and depreciated. This simplifies bookkeeping for minor items.

Q: Can I depreciate land or software development costs?
A: Land is not depreciated because it is considered to have an indefinite useful life. Certain software development costs, however, can be capitalized and amortized (the equivalent of depreciation for intangibles) once the project reaches technological feasibility, according to US GAAP and FRS 102 guidelines.