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How is Depreciation treated in the calculation of Cash Flow?
Although depreciation does not affect the cash flows in a direct manner, it has an indirect influence on the latter. Depreciation is a non-cash item and so financial managers must know how depreciation affects the cash flows in order to present an accurate figure of cash flows.
What is Depreciation?
Depreciation is a concept in accounting wherein the loss of value of an asset is considered. Whether it is machinery, computing equipment or office stationery, all tangible assets lose value over time. In that manner, all tangible assets have a value of zero after its useful life. This reduction of value of an asset is known as depreciation in accounting.
Business owners need to be aware of depreciation because it helps to calculate the true cost of doing business. All tangible assets lose value over time and if this is underestimated, the value of business may be affected. Moreover, depreciation is tax-deductible and so it can hit the bottom-line of a business.
Impact of Depreciation on Cash Flow
Depreciation does not impact cash flow directly. However, as it impacts the taxes, it affects the net cash outflows of a business. How does this impact the business? Here are the details.
When a company lists its returns, depreciation is listed as an expense. This reduces the taxable income that has to be reported to the government. So, it reduces the cash going out of the businesses.
Therefore, the depreciation costs have to be subtracted from the net income of the business. This helps companies in reducing the burden of assets that lose value over time, saving money that can be used for acquiring new assets.
The effect of depreciation on Cash flow can be increased even more by using accelerated depreciation methods, such as the double-declining method. This enlarges the tax-deductible income and businesses can save even more outflow of cash by using them.
As lower taxes lead to increased net income, calculation of depreciation leads to higher net income. Without the use of depreciation, the net income of companies will, therefore, reduce, diminishing the net worth of the business.
Net Depreciation Impact on Cash flow
It must be noted that depreciation exists only due to the existence of fixed assets and the effect of depreciation would be diminished when new assets are acquired. The purchase of new assets causes net cash outflow. So, the positive impact of depreciation on the net income is canceled by the original expenses.
Depreciation in Cash Flow Statement
Depreciation is present in a business’s cash flow statement, accounting statement, and balance sheet. It is a non-cash item which means that it has to be added back to the cash flow statement in the operating activities section along with other expenses, such as depletion and amortization.
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