Why Does Depreciation Affect the Level of Cash Flow?
Cash is king, and a company's cash flow statement reveals its cash position from its operating, investing and financing activities. Depreciation appears in the operating activities section of the cash flow statement. But because it is a non-cash expense, analysts add it back to operating income to determine a company's true cash position.
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Depreciation
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Depreciation is the process of allocating an estimated expense to an asset's useful life. The most commonly used depreciation method is straight-line depreciation, which spreads the expense evenly throughout the life of the asset. For example, the annual depreciation is $10,000 for a piece of equipment costing $100,000 with a 10-year useful life ($100,000 divided by 10). After year one, the value of the asset on the company's balance sheet is $90,000. Depreciation is charged to a contra-asset account called "accumulated depreciation," which is deducted from the value of the asset. However, depreciation is a non-cash expense. Thus, the $10,000 is really cash available to the company.
There are two additional methods for depreciation of assets: sum-of-the-years' digits and double-declining balance. Both are aggressive depreciation methods because they allocate greater depreciation expense in the early part of the asset's life.
Cash Flow
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How fast cash comes in and out of a company is crucial to its operating health. In general, a company can generate cash from running its business, its investments and borrowing money. The cash flow statement divides a company's cash position into three categories: operating activities, financing activities and investing. Ideally, a company should generate most of its cash from its operating activities.
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Operating Income
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Operating income is the profit remaining after a company takes into account its operating expenses from sales. Operating income is sales minus cost of goods sold, minus all operating expenses. To get a true picture of a company's operating income, remove depreciation from expenses because it is a non-cash expense. Operating income, or earnings before interest and taxes (EBIT), is a measure of a company's earnings power. Having a high level of operating income, or EBIT, gives a company greater flexibility to reinvest in the business, pay dividends or make acquisitions.
Insight
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Even after subtracting depreciation expense, operating income may still not be reflective of a company's true earnings power. This is because management has discretion over which depreciation method its uses and its estimation of an asset's useful life. A company using an aggressive depreciation method such as sum-of-the-years' digits shows higher adjusted operating income than one using straight-line depreciation.
Compare a company's depreciation practices to that of its competitors to determine whether it is depreciating its expenses on par with the industry. For example, if most of a company's competitors use straight-line depreciation, adjust the company's operating income by switching the depreciation method to fall in line with its peers. A company's depreciation policy is located in the footnotes of its annual report.
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References
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