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### Course: Finance and capital markets>Unit 5

Lesson 3: Depreciation and amortization

# Depreciation in cash flow

Depreciation in Cash Flow. Created by Sal Khan.

## Want to join the conversation?

• I don’t understand why one adds back Depreciation to the Cash from Operations in the Cash Flow Statement as a positive value. The truck didn’t give u back \$20 to put in your pocket each year. Doing this feels like you just got a free truck.
• I was momentarily taken aback as well, and then suddenly remembered that it was a cash flow statement, not and income statement I was looking at. The table at the top is a very simplified income statement, so the depreciation expenses would reduce your operating profit. In the cash flow, however, you are essentially spinning this around to focus on the cash side. Your profit was \$30K (\$100K - \$50K - \$20K), so that cash comes in. But while depreciation is an expense, it is not a cash expense. (In other words, you didn't spend \$20K out of the net new \$50K added to the checking account over the year.) So, to recognize the \$50K as "Cash from Operations", you have to add that \$20K back to the net profit to balance to that \$50K in cash received. Note that there was a capital expenditure which "burned" the \$60K you started the year with. So, you started with \$60K, but bought the truck (leaving you with \$0), then brought in \$100K in revenue, while paying out \$50K in labour (leaving you \$50K in the bank). Depreciation affects profit/loss numbers, but not cash (the capital expense, however, does). Hope I explained this in an understandable form.
• I still don't understand why the \$20 depreciation is added in the cash flow statement. Can someone please explain?
• why not just not include depreciation at all in the cash flow statement. depreciation and amortization have nothing to do with cash changing hands.
• They are not "included" in the cash flow statement, but if you start with net income to generate your cash flow statement, then you have to add them back to take them out.
• I don't understand why the depreciation has to be added back at all. One way I looked at it was as using the truck meant 20k of its value is infused to your business during operation. but here again it is not profit. if we don't add the 20k back, the cash from operations and operating profits are both 30k and match. why should we add it back? Someone please explain this to me. I went through the comments still didn't get a proper sense of it.
• I don't know if this will answer your question but if I'm not wrong, the 20k is added to the cash account because what you are doing is investing in a truck, that is, you are not losing money, the only thing you are doing is transforming those 60k (cash) into an asset (a truck, which is despised "loses its value") so this in itself is not taken as a loss, and on the other hand that 20k is added as profit because your cash is not really coming out of anywhere, that is, you are not paying 20k every year, you only paid 60k one year and that's it, but in the stable account table you put it in negative numbers (you subtract it) because this way your profits are shown in a more consistent way. Maybe it just makes things more complicated for you hahaha, but I hope this helps you.
• If I recall correctly, the reason that we have to add back the depreciation expense is because we wanted to make the income statement look steadier, to more accurately reflect the steadiness of the business. It is my understanding that there are several other non-cash transactions that are often included on an income statement. I imagine that this begins to complicate things increasingly. So, my question is this: Is all of the trouble worth making an income statement LOOK steady? Would it not be simpler for income statements to specify the expenses that cause operating profit volatility?

Lastly, what would Khan recommend as the next step in this learning process, for one who wants to get more advanced and learn to read and understand REAL financial statements?

• Here matching principle is being employed. Allocating the cost over the useful life of an asset. And it is apt to say that employing this method is to give a good reflection of the company's ability to make a profit.
(1 vote)
• At , I understand why you are going to add the 2nd and 3rd year. But why the first year do we add 20K the first year. Even if we didn't use the full value of the truck in the first year and we are going to split up the expense between the 3 years. Why the first year do we add? And if anything you should say the first year we add 40k 2nd year 20k and last year none.
(1 vote)
• You add whatever was subtracted as an expense to arrive at net income.
If you bought it at the beginning of the first year, you used up some it during that year, and that's an expense but it is a not cash expense.
• If we paid for the truck upfront at \$60k, why would we be adding 20k back each month for depreciation? I understand if we spread this cost out and it was \$20k per year, but this make it seem like the total cost of the truck, plus a \$20k expense each year. Are we saying that the truck's value stays the same and we get \$20k back each year?
(1 vote)
• At , it is said that we are spreading the "cost" of the truck over three years, then why is it not a cash expense? Would it not make sense to put 60k in the income statement in the first year and then start depreciating it by 20 each year?
(1 vote)
• No one has satisfactorily explained why depreciation is added to profit in the cash flow statement. An excerpt from another site to contextualise my question.

I found this, "Even though depreciation is a legitimate expense and must be recognized, it is not a cash outlay. Therefore, the cash position of the company must be greater by that amount than is indicated by the profitability figure alone." [source: http://smallbusiness.chron.com/happens-depreciation-not-added-back-cash-flow-48904.html]

Now my question is - since depreciation is not a cash outlay it should not reflect negatively in the cashflow statement, why does it then have a positive effect on cashflow? (in my mind it should just be left out)

When i think of cash, i think of the physical asset, i.e. 30k in my hands. How does adding depreciation to profit place 20k more of physical cash in my hands?

Am i thinking about cash incorrectly?

I'm sure there is an explanation out there that will make my brain click but i've read all the comments and read articles on a bunch of different websites and every explanation boils down to "it is not a cash outlay so it should be added to profit" or "to balance the capex effect on the cash flow statement" neither of which goes far enough to explain the reason to add this to profit in the cashflow statement.
(1 vote)
• Depreciation was not a cash expense, but it was subtracted from revenue in order to calculate profit. So if you want to calculate what the cash flow was by starting with profit, you have to add it back.

The key is that you are starting from profit and working backwards.

You could also calculate cash flow by starting from revenue and working forward. Then you wouldn't subtract depreciation in the first place, so the number you come up with for "cash profit" would be higher than your correct accounting profit.

When working backward from profit, first you add back the depreciation that was a non-cash expense that was subtracted from revenue, but then in exchange you have to subtract out capital expenditures, which was a cash expense that was NOT subtracted from revenue to come up with profit.

So if cap ex equals depreciation, the cash flow will be the same as the net income (if there are no other adjustments).
(1 vote)
• The problem I have with this video is that I'm not sure WHERE you're adding or subtracting these figures from: the Income statement? The Balance sheet? The Cash flow? (The figures are "scooted around" so fast).

I get that the original \$60,000 for the truck is a capital expense, but exactly where is that expense shown (I am hoping it's on the Balance sheet under "Property & Equipment"; or the Income Statement under "Costs & Expenses".

In your video, you SUBTRACT the depreciation on the Cash Flow statement; however, right now, I am looking at a 2017 Cash Flow statement from Walmart , but Depreciation is shown as a "positive" number. For example, under Cash Flow/Operating Activities:
14,293 = Net income
10,080 = Depreciation & Amortization
761 = Deferred Income Tax
7,157 = (The rest of the stuff added up)
==================
31,530 = Net Cash

(1 vote)
• Net income, on the income statement, already has depreciation subtracted from it. Depreciation is non-cash, so you have to add it back to net income in order to figure out what the cash flow was. (There are other adjustments as well)

The 60,000 will show as a capital expenditure (not expense) on the cash flow statement. The 60000 never appears all in one shot on the income statement, it is expensed a little at a time over years, on the depreciation line.

The 60,000 will also go on the balance sheet as PPE. If cash was used to pay for it, then the balance sheet has 60k more in PPE and 60k less in cash. Net effect on assets and equity is zero.

I did not watch the whole video but I see him adding depreciation of 20 to net income to find the cash flow. That's the depreciation. But in the year that you bought the truck you paid 60k in cash, and that shows up as a subtraction from cash flow. The next year it won't be there.

If you look at Walmart's CF statement you have to look not just at operating activities but the rest of the cash flow statement, and you will see "capital expenditures" getting subtracted to get to the net cash flow number.

In very summary form, cash flow is

Net income
+ add back depreciation & amortization (because it was an expense but it wasn't cash)
- cap expenditures (which were not included as an expense in calculating net income)
- net increase in working capital (for example an inventory increase, which does not impact income)
= cash flow

In practice you will often see other non-cash expenses besides D&A being added back, and possibly other cash outflows that were not on the income statement being subtracted. This is always detailed on the CF statement and/or in the notes that accompany the financial statements. Always read the notes.
(1 vote)