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Thursday, April 18, 2024

Understanding Depreciation: How it Affects Cash Flow and Profit

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Depreciation expenses have a direct impact on the profit that is visible on a company’s income statement. The bigger the depreciation expense in a particular year, the lower the business’ detailed net income – its profit. But, it’s also important to note the depreciation is a non-cash cost, the expense doesn’t change the cash flow of a business. 

Depreciation is a kind of expense that is utilized to lessen the carrying worth of an asset. It’s the estimated cost that’s normally scheduled instead of being an explicit expense. If you want to know more about depreciation and how it affects profit and cash flow, then keep on reading. 

What is Depreciation?

Depreciation is an expense that can be found on the balance sheet, income statement, and cash flow statement. Depreciation to some extent is arbitrary which affects the value of the assets to rely on the best estimate in most cases. Basically, depreciation doesn’t automatically affect the operating cash flow of the business. 

Companies have several options when managing the carrying value of their asset on their books. A lot of companies would opt for some types of depreciation methods, however, a revaluation is also an alternative. Furthermore, depreciation is also an accounting method for distributing the cost of a tangible asset over time. Companies should be able to carefully pick proper depreciation methodologies that will correctly represent the asset’s value and expense identification. It has a huge impact on a company’s financial overall performance. 

How Depreciation Works

If you’re a business owner and you have a physical asset with a useful life of longer than a year like a building or a vehicle, this will not report the entire cost of an upfront expense. Why? It’s because accounting rules necessitate that the expense is expanded over the useful life of the asset. This is usually done through depreciation. 

For instance, you purchased a new truck for $30,000 cash, and it estimates that the truck has a value of useful life of 10 years. Based on the most common depreciation method, known as the straight-line method, your business will report no direct expense but a depreciation expense of $3,000 each year for 10 years. 

Effect of Depreciation on Profits

Profit is basically the entire sales revenue of a company and any other gains deducted from its expenses and any losses. For example, a $3,000 depreciation expense, then, has the effect of lessening profit by $3,000. It’s crucial that you remember that profit is actually just an accounting creation. 

Like what we’ve mentioned from the truck, your business spent the money directly. It only means that all of the money was gone as soon as you purchased the truck. However, when it comes to your profit-and-loss calculations, you didn’t actually give up any value. Rather, what happened is you just traded $30,000 worth of cash for $30,000 worth of truck. As time goes by and you “use up” that value by using the truck for your business, you are turning the expense into an expense through depreciation. 

Effect of Depreciation on Cash Flow

If you’re using the method of balancing your checkbook by accounting your business for the truck using cash accounting, you would have detailed a $30,000 expense when you bought the truck and no cost at any time afterward. 

Just like what we’ve mentioned previously, you’re under straight-line depreciation, showing no expense at the beginning, then $3,000 per year for 10 years. In every cash flow, your overall profits decrease by $30,000; it’s only a matter of timing. Whichever in these cases, you would still have a $30,000 outflow of cash at the start and no outflow of cash subsequently. 

Tax Accounting

Even though nearly all companies utilize straight-line depreciation for their financial accounting, many would use various methods for tax purposes which is very common and legal. For the calculation of their tax liability, they use an accelerated depreciation schedule that moves nearly all the depreciation to the initial years of the asset’s useful life. This can produce a bigger expense in those years, which only means lower profits because businesses acquire tax on their profits, meaning a lower tax bill in the prior years.

On the Note 

To get the most of your depreciation and for you to use it properly, it would be best that you invest in the brands you love and those that are renowned. When you use world-class brand names daily and every day, you are already aware that their products work really well and they are known to have high-quality. Why not use that knowledge and profit from it? Investing in what you know is a popular investment technique and a wise strategy to get started in stock investing. 


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