Depreciation is a noncash accounting charge and does not have a direct impact on the amount of cash flow generated by a company. 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 and Cash Flow
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value over time.
Depreciation spreads the expense of a fixed asset over the years of the useful life of that asset. Depreciation helps companies avoid taking a huge deduction in the year the asset is purchased, allowing companies to earn revenue from the asset. For example, if a company buys a company vehicle for $30,000 and plans to use it for the next five years, the depreciation expense would be $6,000 per year.
Net income is calculated, in part, by deducting expenses, like depreciation, from income earned during the period. However, net income is used as the starting point in calculating a company's cash flow. Since depreciation was taken out when calculating net income and is not a cash outlay, depreciation is added back in when creating the cash flow statement.
In other words, depreciation is an accounting measure and is added back into revenue or net sales when calculating a company's cash flow. As a result, depreciation does not affect cash flow. However, depreciation can have an indirect impact on cash flow.
Depreciation, Taxes, and Cash Flow
Since depreciation is listed as an expense, it reduces the amount of taxable income. Of course, tax laws can vary, but if depreciation is allowed to be a tax-deductible expense, it will reduce the tax payment for a company.
With the company paying less in taxes, net income would be higher. And since net income is used as the starting point for calculating cash flow, net income would be higher as a result of the tax benefit deduction of depreciation. Although depreciation does not involve an outlay of cash, it could indirectly boost net income if depreciation expenses are a tax deduction, reducing the cash outlay for a company's taxes.