Depreciation can be quite a complex topic of discussion, especially when your business’s cash flow is the focal aspect being considered. While depreciation may be a non-cash expense, it does have an impact on and influences cash flow — be it indirectly.
In this post, we’ll take a closer look at depreciation and answer questions such as ‘how does depreciation affect cash flow statements?’ amongst others. So, if you’re looking to learn more about depreciation in general or the way in which it influences cash flow, you’ve just stumbled upon the perfect blog post.
What is Depreciation?
Put simply. Depreciation is a concept in accounting where assets lose value over time — they depreciate. Once it depreciates to a certain point, the asset’s value will become zero as it’s no longer usable or useful to the business. Depreciation is used to spread the cost of tangible assets over the course of their ‘useful life’. Depreciation can occur with pretty much any type of fixed asset, including IT hardware, machinery, office supplies, and much more.
Business owners should not only understand depreciation but also how to calculate it. Not only because it has an impact on your finances but also because it opens your eyes to the true cost of doing business. After a period of time, assets may need replacing. If you haven’t considered this or factored it into your budget, you’ve simply underestimated the cost of running a business. And, well, overlooking it could prove to be a costly mistake. Additionally, depreciation is tax-deductible, which could influence your company’s bottom line.
How Does Depreciation Impact Cash Flow?
The first thing to note is that depreciation doesn’t directly impact the cash flow generated by businesses. However, it is tax-deductible and reduces cash outflows relating to income taxes. Depreciation is categorised as a ‘non-cash expense’ as it’s simply an ongoing charge for a fixed asset that diminishes over time to remain in line with the condition/life of the asset, often due to wear and tear. When you create a budget for cash flow, depreciation tends to be listed as a reduction from expenses, implying it has no impact on cash flows. Regardless, depreciation does indeed have an indirect influence on cash flow.
When companies prepare income tax returns, they list depreciation as an expense and reduce the taxable income reported. If depreciation is an allowable expense to calculate taxable income, it lowers the amount of tax that a company must pay. Therefore, depreciation affects cash flow by reducing the expense a business must pay in income taxes.
This tax effect of depreciation can also increase if the government allows your business to use ‘accelerated depreciation’ to increase the amount you claim as a taxable expense. This further reduces the cash outflow for tax payments for a short period. However, this does leave less depreciation available to claim later on, reducing the favourable tax effect in those periods).
Depreciation exists because it’s associated with a fixed asset. And there was a cash outflow to pay for the fixed asset when it was purchased. Meaning the net positive effect on your cash flow of depreciation is nullified by the consistent payment for a fixed asset.
Net Depreciation Effect on Cash Flow
Although technically depreciation has a positive impact on cash flow, be it indirect, it’s always important to keep in mind that depreciation only plays a part because it’s attached to a fixed asset. However, the original purchase of the fixed asset directly impacts cash outflow, meaning that overall, the positive effect seen from depreciation is actually nullified by the original expense.
How Does Depreciation Affect Cash Flow Statements?
If you’re wondering if or how much your fixed assets have depreciated, you can find this information on your income statement, balance sheet, and your cash flow statement. But why does depreciation get added into cash flow? Well, it’s actually very simple. Depreciation is considered to be a non-cash expense, meaning it’s added back onto your cash flow statement within the operating activities section, as well as other expenses such as depletion.
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