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Depreciation is found on the financial statements of just about any company that owns assets, unless the assets increase in value over time. Instead of showing an asset purchase impact all at once, depreciation allows companies to expense the purchase of assets over a set number of years, resulting in a more accurate picture of annual profitability.
Depreciation is a type of non-cash expense which reduces the value of buildings, equipment, cars, machinery and other capital assets over time. Depreciation in a given period is calculated based on the original asset cost and spread out over the asset’s useful life. Each year, as part of an asset is used up, that portion is shown as a depreciation expense on the income statement.
The portion of depreciation expense that is shown on the income statement is the only portion of depreciation that is considered an "add-back." The amount varies based on the value of the company's assets, their remaining life and the method of depreciation used. The chosen depreciation method dictates whether the cost of an asset will be expensed evenly across its useful life, or have a value that declines more quickly in the earlier years.
EBITDA is an acronym for a company's earnings before any interest, taxes, depreciation and amortization have been factored in. The EBITDA calculation requires depreciation expense to be added back, since it was subtracted out as an expense in the original earnings calculation. In other words, interest, taxes, depreciation and amortization are all added back to a company's net income to arrive at EBITDA. EBITDA is commonly used as a metric to value companies by applying a multiple to EBITDA. Similar-sized companies in the same industry tend to sell for a certain similar range of EBITDA multiples.
Free Cash Flow
Free cash flow is a metric used to assess and analyze companies that also uses depreciation as an add-back. Free cash flow shows a company's ability to pay its debt and dividends, invest in business growth and buy back its stock. Free cash flow shows how much cash the company has left after it pays the costs of ongoing operations and invests in new business initiatives. Starting with net income, depreciation and amortization are added back, then capital spending and the change in working capital are both removed, to arrive at free cash flow.
- The Motley Fool; Foolish Fundamentals: Free Cash Flow; September 2007
- "Inc." magazine; What's Your Business Really Worth?; Norm Brodsky; April 2005
- The Accounting Coach; Introduction to Depreciation; Harold Averkamp
- Internal Revenue Service (IRS). "Topic No. 704 Depreciation." Accessed July 26, 2020.
Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer and editor for several online finance and small business publications since 2011, including AZCentral.com's Small Business section, The Balance.com, Chron.com's Small Business section, and LegalBeagle.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.