What is the Connection Between Depreciation and Cash Flow?

The connection between depreciation and cash flow is that depreciation is a non-cash expense that reduces cash flow reported in a company’s net income statement. Cash flow is the money coming in and going out of a company through operating, investing, and financing activities. Depreciation is the annual reduction of equipment value to reflect its use in a company. Preparing the cash flow statement will require accountants to add back depreciation to offset the reduction of cash listed in the accounting ledger.

Depreciation and cash flow are two essential accounting figures that relate to the assets owned by a company. Rather than companies expensing large-scale machine or equipment purchases at one time, accounting standards allow them to record the item as an asset. The depreciation represents an expense a company will post each month that represents the use of the item by the business. Therefore, depreciation is simply an accounting measurement posted after cash was spent by the company.

Under the accrual accounting method — the preferred method by most accounting principles and standards — companies record transactions as they occur, regardless of cash changing hands. Companies are unable to keep an accurate cash balance recorded in their general ledger cash account since payments will be made for transactions in previous accounting periods. To create an accurate picture of cash, accountants prepare the cash flow statement. Depreciation and cash flow fall under the operating section, which lists all the normal activities that generate cash in a business.

Calculating operating cash flow starts with the company’s net income, taken from the company’s income statement, but depreciation — a pure accounting figure — reduces net income. Accountants will add back current depreciation expense in order to rectify this accounting entry. Companies may calculate depreciation in a number of different methods.

The purpose of the cash flow statement is to provide internal and external stakeholders with a review of a company’s cash position. Although companies may be reporting high levels of net income, they may actually be cash poor. This occurs when a company makes most of its sales on credit, allowing customers to set up accounts receivables that allow them to pay for goods over services over time. Depreciation and cash flow can have negative results if a company purchases significant amounts of fixed assets, resulting in large amounts of depreciation.