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Depreciation in cash flow

Depreciation in Cash Flow. Created by Sal Khan.

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  • blobby green style avatar for user Gene Chuang
    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.
    (59 votes)
    • leaf green style avatar for user Charles Ormiston
      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.
      (127 votes)
  • blobby green style avatar for user yilinhuo
    I still don't understand why the $20 depreciation is added in the cash flow statement. Can someone please explain?
    (6 votes)
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  • duskpin sapling style avatar for user Hayden
    why not just not include depreciation at all in the cash flow statement. depreciation and amortization have nothing to do with cash changing hands.
    (2 votes)
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  • leaf green style avatar for user Hrithu Olickel Arumaraj
    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.
    (3 votes)
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    • starky ultimate style avatar for user homero gazze
      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.
      (2 votes)
  • piceratops seed style avatar for user Matthew West
    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?

    Thank you for your work.
    (2 votes)
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  • spunky sam blue style avatar for user Naftali
    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)
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  • blobby green style avatar for user Matthew Kingsley
    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)
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  • blobby green style avatar for user Qasim Shafi
    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)
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  • blobby green style avatar for user philash
    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)
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    • male robot hal style avatar for user Andrew M
      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)
  • blobby green style avatar for user Mark M
    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

    Why does Walmart ADD the depreciation, while your video subtracts it?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      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)

Video transcript

Let's see if we can better understand what a cash flow statement for my simplified shipping truck example company would actually look like. Now I say it's simplified because this is a very simplified income statement for each of these periods. I'm not really showing all the expenses or all of the details that you would actually have for a shipping company but we really just care about the accounting. So let'a just say that at the beginning of this fiscal year, when I started this company, I had $60,000. We know from our example that we used that $60,000 to buy a $60,000 truck. And on the cash flow statement you express that saying "I spent $60,000 on Capital Expenditure" sometimes it's "property plant and equipment". So you would actually put the $60,000 right over here, on capital expenditures. and hopefully we'll understand this in a little bit Now remember, the cash flow statement is really a way of reconciling the profit with the starting and the ending cash. So let's just think about this a little bit. Our profit here, if we just take the number that we have here, Our profit in the first period is $30,000. We're assuming nothing shady is happening with the Accounts Payable, Accounts Receivable, that they're not changing over the course of the year. And then we have depreciation, and we want to think a little bit in this video, what does the depreciation do to the cash flow statement? So I'll just write down the number first. So we have this depreciation value. This is the truck depreciation. It's not just the expent value of the truck, we're spreading that cost over 3 years. So $20,000 over 3 years is the life of that truck. So the depreciation in each of these periods is $20,000. And what I'm going to show you here is, To figure out the cash from operations from actually how much cash the operations are producing. We want to add back this depreciation to the profit so our cash from operations is going to be $50,000. And it might not seem obvious to you at first, but I want you to think about it. This $20,000 that we're showing as an expense in every period, and it actually might be more obvious if we think about period 2 or period 3 We're showing it as an expense but $20,000 did not go out of the door in year 2, or year 3. We're just showing some of the expense from previous years. So no cash went out of the door. So in any of these periods, the depreciation expense should be added back to the operating profit, to figure out the cash from operations. And you might say "Wait! But we spent that $60,000, especially in year 1" And that goes here, under Capital Expenditures. The operations didn't push that cash up, the business itself, this is just an investment that we made. So it all works out, because what we see is that we got $50,000 cash from operations, and that makes sense because our revenue was $100,000 just the labor, the cash labor, people's salaries, were $50,000 So that's $50,000 of profit. This was not a cash expense, so from our operations we had $50,000 dollars, But then we did have the capital expenditures of $60,000 for the actual truck. So our ending cash would be $60,000+$50,000-$60,000. So our ending cash is going to be $50,000 Now it might make a little bit more sense if we go to the next period. Our starting cash here is $50,000. It's our ending cash of the previous period. Our profit, once again, is $30,000. You add the profit to the depreciation, you get a $50,000 operating profit same as the previous year. Or I should say cash form operations, and that makes sense, because our operations really haven't changed. We have a very, very steady business. But this year, I have no capital expenditures. So I'm using the same truck as last year. So now Our ending cash: Our starting cash was $50,000, we had $50,000 from operations, now our ending cash is $100,000. So hopefully that gives you a sense of why we add back depreciation when we figure out the cash from operations and how it works out in our cashflow statement.