Depreciation is a non-cash accounting entry. It is considered an expense but no check is ever written to someone. So does it have an effect on cash flow? Surprisingly, it does.
Depreciation does not directly impact a company's cash flow, but it does so indirectly by changing the company's tax liabilities.
Businesses record revenues and expenses to determine their net income. Most expenses, such as labor, materials, utilities and insurance premiums, are recorded on a company's income statement when they are consumed and paid. However, fixed assets receive a different accounting treatment.
Fixed assets — like a piece of machinery, for example — do not wear out in just one year, but instead depreciate in use and value over a span of years. The amount of that decline in value is a non-cash depreciation charge that is recorded on the company's income statement.
As a formal definition, depreciation is an accounting procedure that allocates the cost of a tangible asset over its useful life. Businesses use several accounting methods to calculate the amount of annual depreciation costs for both management and tax purposes. While business owners can select a depreciation method for their internal reports, the IRS has its own rules regarding which procedures can be used for tax filings.
The four most commonly used depreciation methods are:
- Straight-line: To find the annual straight-line depreciation expense, take the cost of the asset, subtract the salvage value and divide by the useful life of the asset. This method is the simplest way to calculate the amount of depreciation.
- Double-declining balance: The double-declining balance method depreciates an asset at twice the rate of the straight-line method. This is known as accelerated depreciation.
- Units of output: The value of the asset is depreciated based on units of production volume.
- Sum-of-the-years digits: This is another form of accelerated depreciation with larger deductions taking place in the early years of the asset's life.
Let's take an example to illustrate the effect of depreciation on cash flow. Consider the following data:
- Purchase price of a piece of machinery: $150,000
- Useful life: 5 years
- Salvage value: $0
- Company's marginal tax rate: 25%
- Earnings before deductions for depreciation: $200,000
- Taxes on earnings: $50,000 ($200,000 X 25%)
The annual depreciation expense using the straight-line method would be $30,000 ($150,000/5 years). After deducting this depreciation expense, the company's earnings become $170,000 ($200,000 less $30,000). As a result, the tax liability goes down to $42,500 ($170,000 X 25%), a reduction of $7,500.
Thus, you can see that a non-cash deduction for depreciation actually creates a lower tax liability and a reduction in cash outlay of $7,500.
Let's look at the same example, but calculate the effects on cash flow of using the double-declining balance (DDB) method. Under the DDB method, the depreciation for the first year is twice the rate of the straight-line method. Therefore, the company's earnings with this double-depreciation deduction become $140,000, leading to a tax liability of $35,000. Now, the company has reduced its cash outlay for taxes by $15,000 compared to the straight-line method.
The result is that while depreciation deductions do not directly impact a company's cash flow, they do affect it indirectly by changing the tax liabilities.
The difference between using depreciation on an income statement vs. a cash flow statement to find cash flow is that the indirect method relies on calculating the changes in balance sheets accounts. Another way to see the effects of non-cash entries is to add back depreciation for tax statements. This will give an estimate of cash flow.