Depreciation can be a tricky subject, particularly when it comes to its effect on your business’s cash flow. Although depreciation is a non-cash expense, it influences cash flow in an indirect way.
Want to know more? Check out our guide to the impact of depreciation on cash flow for a little more information. We cover a broad range of areas, including the definition of depreciation and depreciation’s effect on cash flow.
What is depreciation?
Put simply, depreciation refers to a concept within accounting wherein assets lose value over the course of time. After a certain point, the value of an asset will become zero, because it’s no longer useful to the business.
Within accounting, depreciation is used to spread the cost of a tangible asset over its “useful life”. Depreciation can happen with almost any type of fixed asset, including machinery, computing equipment, office supplies, and so on.
It’s important for business owners to understand how to calculate depreciation because it helps you to determine the true cost of doing business. After a certain amount of time, your assets may need to be replaced, and if this isn’t factored into your revenue projections, you may be underestimating the costs your business will need to deal with. In addition, depreciation is tax-deductible, which can have a major impact on your business’s bottom line.
What’s the impact of depreciation on cash flow?
Depreciation does not have a direct impact on cash flow. However, it does have an indirect effect on cash flow because it changes the company’s tax liabilities, which reduces cash outflows from income taxes. How does this work, exactly? Let’s look in a little more detail.
Essentially, when your company prepares its income tax return, depreciation will be listed as an expense. This reduces the amount of taxable income you need to report to the government, reducing the amount of cash that goes out of your business.
Depreciation’s effect on cash flow may be increased even more if it’s possible to use accelerated depreciation methods, such as double-declining depreciation. This increases the amount of depreciation that counts as tax-deductible, reducing your taxes even further.
Put simply, lower taxes lead to increased net income, and as net income is often used as a starting point to calculate a business’s operating cash flow (along with net change in operating working capital and other adjustments), you’ll end up with a higher amount of cash on your cash flow statement.
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What’s the net depreciation effect on cash flow?
Although cash flow has an indirectly positive impact on cash flow, it’s important to remember that the only reason depreciation exists is because it’s connected to a fixed asset. Now, the original purchase of the asset would have resulted in a cash outflow, which means that overall, the positive impact of depreciation on cash flow is cancelled out by the original payment.
Depreciation in cash flow statement
You can find depreciation on your cash flow statement, income statement, and balance sheet. Why is depreciation added in cash flow? It’s simple. Depreciation is a non-cash expense, which means that it needs to be added back to the cash flow statement in the operating activities section, alongside other expenses such as amortization and depletion.
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May 14, 2022 May 14, 2022/ Steven Bragg
The direct method of presenting the statement of cash flows presents the specific cash flows associated with items that affect cash flow. Items that typically do so include:
Cash collected from customers
Interest and dividends received
Cash paid to employees
Cash paid to suppliers
Interest paid
Income taxes paid
The advantage of the direct method over the indirect method is that it reveals operating cash receipts and payments.
The standard-setting bodies encourage the use of the direct method, but it is rarely used, for the excellent reason that the information in it is difficult to assemble; companies simply do not collect and store information in the manner required for this format. Using the direct method may require that the chart of accounts be restructured in order to collect different types of information. Instead, they use the indirect method, which can be more easily derived from existing accounting reports.
Lowry Locomotion constructs the following statement of cash flows using the direct method:
Lowry LocomotionStatement of Cash Flows
for the year ended 12/31/x1
| Cash flows from operating activities | ||
| Cash receipts from customers | $45,800,000 | |
| Cash paid to suppliers | (29,800,000) | |
| Cash paid to employees | (11,200,000) | |
| Cash generated from operations | 4,800,000 | |
| Interest paid | (310,000) | |
| Income taxes paid | (1,700,000) | |
| Net cash from operating activities | $2,790,000 | |
| Cash flows from investing activities | ||
| Purchase of property, plant, and equipment | (580,000) | |
| Proceeds from sale of equipment | 110,000 | |
| Net cash used in investing activities | (470,000) | |
| Cash flows from financing activities | ||
| Proceeds from issuance of common stock | 1,000,000 | |
| Proceeds from issuance of long-term debt | 500,000 | |
| Principal payments under capital lease obligation | (10,000) | |
| Dividends paid | (450,000) | |
| Net cash used in financing activities | 1,040,000 | |
| Net increase in cash and cash equivalents | 3,360,000 | |
| Cash and cash equivalents at beginning of period | 1,640,000 | |
| Cash and cash equivalents at end of period | $5,000,000 |
Reconciliation of net income to net cash provided by operating activities:
| Net income | $2,665,000 | |
| Adjustments to reconcile net income to net cash provided by operating activities: | ||
| Depreciation and amortization | $125,000 | |
| Provision for losses on accounts receivable | 15,000 | |
| Gain on sale of equipment | (155,000) | |
| Increase in interest and income taxes payable | 32,000 | |
| Increase in deferred taxes | 90,000 | |
| Increase in other liabilities | 18,000 | |
| Total adjustments | 125,000 | |
| Net cash provided by operating activities | $2,790,000 |
May 14, 2022/ Steven Bragg/