A:

Depreciation is a noncash accounting charge and does not have a direct impact on the amount of cash flow generated by a business or project. However, as long as there is sufficient taxable income to absorb it, depreciation is a tax-deductible expense and reduces tax cost, which has a positive impact on cash flow.

Depreciation in Financial Reporting

In accounting, the depreciation expense is used to allocate costs of long-lived assets in a rational, systematic pattern over the period the assets are expected to provide economic benefits. Therefore, in calculating operating results under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), depreciation is a deduction in arriving at income before income taxes. Because it is a noncash deduction, in a cash flow statement prepared under financial accounting standards, depreciation is presented as an adjustment in reconciling net income to operating cash flow.

Depreciation in Cash Flow Forecasts

While depreciation does not directly affect cash flow, the tax shield it provides can be an important part of cash flow forecasts used in financial analysis and capital budgeting. Depreciation is often calculated under different methods for financial accounting standards than for tax purposes.

The amount of the tax shield in any year is calculated by multiplying the tax-basis depreciation expense by the marginal tax rate applicable for that year. This tax shield is added to the after-tax operating cash flow forecast.

Suppose a forecast for a year shows sales of $2.5 million, cash operating expenses of $1.5 million, depreciation of $0.5 million, working capital and capital expenditures of $0.6 million, and a 40% tax rate. After-tax operating cash flows are (($2.5 million - $1.5 million) x (1 - 40%)) - $0.6 million, or zero. The tax shield is $0.5 million multiplied by 40%, or $0.2 million. Combining after-tax operating cash flow and the tax shield equals forecast cash flow of $0.2 million.

RELATED FAQS
  1. Are taxes calculated in operating cash flow?

    Learn how taxes are involved with the calculations for operating cash flow, and find out about the importance of operational ... Read Answer >>
  2. What is the relationship between accumulated depreciation and depreciation expense?

    Understand the relationship between accumulated depreciation and depreciation expense. Learn how each one is accounted for ... Read Answer >>
  3. What will examining a company's cash flow from operating activities tell an investor?

    Understand what examining a company's cash flow from operating activities tells an investor. Learn why the cash flow statement ... Read Answer >>
  4. Why do analysts look at operating cash flow?

    Learn how operating cash flow is used to determine financial health. Examine how cash flow is calculated, and what a low ... Read Answer >>
  5. What is the difference between cash flow and free cash flow?

    Learn about the main differences between cash flow and free cash flow. In addition to the differences, learn how to calculate ... Read Answer >>
Related Articles
  1. Investing

    Cash Flow Statement and Financial Health

    A cash flow statement records the amounts of cash and cash equivalents entering and leaving a company.
  2. Investing

    Analyze Cash Flow The Easy Way

    Find out how to analyze the way a company spends its money to determine whether there will be any money left for investors.
  3. Investing

    Evaluating A Statement Of Cash Flows

    The metrics for the Statement of Cash Flows is best viewed over time.
  4. Investing

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  5. Investing

    Cash Flow From Investing

    Cash flow analysis is a critical process for both companies and investors. Find out what you need to know about it.
  6. Investing

    Cash Flow On Steroids: Why Companies Cheat

    Pressure to be the best can sometimes push corporations to cheat. Learn how they do it and how to spot it.
  7. Investing

    Fundamental Case Study: Is Amazon's Cash Flow Actually Solid? (AMZN)

    Review Amazon's cash flow situation, including its free cash flow yield, operating cash flow from organic growth and cash flow from debt financing.
  8. Investing

    Cash Flow Statement: Reviewing The Cash Flow From Operations

    A company's ability to consistently generate positive cash flows from its daily business operations is highly valued by investors. Operating cash flow can uncover a company's true profitability ...
  9. Small Business

    Understanding Cash Flow

    Learn about the different types of cash flows and the importance for businesses to properly manage their cash flows.
  10. Investing

    What Is A Cash Flow Statement?

    Learn how the CFS relates to the balance sheet and income statement as a part of a company's financial reports.
RELATED TERMS
  1. Operating Cash Flow - OCF

    Operating Cash Flow (or OCF) is a measure of the amount of cash ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out ...
  3. Operating Cash Flow Ratio

    A measure of how well current liabilities are covered by the ...
  4. Cash Flow From Operating Activities (CFO)

    Cash Flow From Operating Activities (CFO) is an accounting item ...
  5. Depreciation

    1. A method of allocating the cost of a tangible asset over its ...
  6. Annuity Method Of Depreciation

    A method of depreciation centered around cost recovery and a ...
Hot Definitions
  1. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  2. Frexit

    Frexit – short for "French exit" – is a French spinoff of the term Brexit, which emerged when the United Kingdom voted to ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
Trading Center