Does depreciation affect cash flow?
It’s finally easy to understand what is deprecation, how it affects cash flow and how it gets charged. Once you do, you’ll set your business up for success.
You just bought a new machine for your business. It’s beautiful and shiny, and you’ve got your entire team excited to use it. Over the years, it becomes well loved, well used, and it makes your business lot of products and profits with its productiveness.
As expected, it also accumulates some wear and tear as time goes on, and meanwhile technology advances. By the time you’re ready to replace it, its value is much, much less than you originally paid for it.
This decrease in value is called depreciation. Here’s what you need to know about how deprecation affects your cash flow statement and your long-term financial planning, plus the tax implications.
What is depreciation?
Deprecation is the decrease in physical asset value, like the factory equipment that produces guitars. When deprecation is talked about in business, you’ll see it referred, first of all, to how the physical value of the asset keeps decreasing as time goes on, and the more you use it.
Therefore, you’ll also see discussions regarding deprecation on your cash flow statement. Deprecation gets listed as a non-cash expense on financial statements across the years you use the asset. This impacts your cash flow forecasting, net income, and even how many taxes you pay.
Types of depreciation methods
There are multiple ways for businesses to list and charge deprecation. We’ve gathered some of the most popular ones.
Straight line
Here, a business takes the cost of a machine (say, $100,000) and divides it by the years, quarters or months it plans to use the machine (say, five years). The same amount gets listed for deprecation in every accounting period, just like a straight line on a graph.
This is done until the asset reaches either zero value or a value that can be saved (for example, by selling the used machine).
Declining balance and double declining balance
While the straight line method assumes an asset’s value gets diminished gradually and equally over time, the declining balance method assumes that the value gets diminished much faster in the early years of usage. That’s why some call this method the “diminishing value” method.
Then there’s the double declining balance method, which is similar to the declining balance method but depreciates assets twice as fast. Assets that become obsolete quickly, like many electronics, are a good fit for this method.
Sum of years’ digits
This method assumes that an asset’s benefit to a business is the greatest when it’s initially used. This benefit declines over the years the more the asset gets used. Simultaneously, the impact of this asset on cash flow is the greatest when the asset first gets used.
Ideally, the business includes the asset in its cash flow recovery strategies and, hopefully, recovers the cost over time. It might even drive profits.
Therefore, this method assumes that deprecation should be charged most in the initial years, and in an accelerated way (although not as accelerated as the declining balance method). Businesses who use this method tend to charge deprecation the least in the last relevant year, as most of the financial investment in the asset has hopefully been returned.
The distinction between depreciation and cash outflow
Just like the cash flow vs. profit confusion, understanding the distinction between deprecation and cash outflow takes a moment. After all, they both relate to the cost of doing business. So let’s take a look.
Does money literally go out of your account?
Cash outflow is all the money literally going out of your business account. This includes paychecks, supply shopping, bills, taxes, business investments, debt payments, interest rates, etc. To understand your cash outflow during a given time (a month, quarter or year, for example), add up all your expenses during that period.
Like cash outflow, deprecation helps create a clearer picture of your business’ financial health. After all, if you bought a machine for $100,000 and it will need to be replaced in five years, when it’ll only be worth, say, $15,000, you need to know this.
So why is deprecation a non cash expense?
That’s because money isn’t actually going out of your account. The machine is standing in your factory, manufacturing guitars. It’s just that, when you calculate your business’ entire physical asset value—real estate, products, machines, etc—deprecation helps you take into account that your machine’s financial worth keeps decreasing.
If that’s the case, does deprecation go on the income statement?
Which one goes on your income statement?
Both deprecation and cash outflow go on the income statement. There, cash outflow—or expenses—get deducted from the overall earnings, to discover the business’ profits.
But while cash outflow signifies the business’ entire spending, deprecation gets listed as part of the operational expenses.
Example of how depreciation affects cash flow
Let’s say your business manufactures guitars and sells them to stores. If you buy a machine for your factory for $100,000, use it frequently for five years, and then want to sell it, it will no longer be worth $100,000. Likely, you’ll be able to sell it for much less.
Let’s assume your business estimates a 30% year over year deprecation.
- By the end of the first year, your machine will likely be worth $70,000.
- By the end of the second year, it will likely be worth $49,000.
As mentioned above, the deprecation gets added to the cash flow statement as an operational expense. But why is deprecation added back to cash flow statements if no cash actually goes in or out of the business once the machine is fully paid for?
Simply, it helps reconcile the net cash that operating activities generate thanks to this machine. You might be generating $200,000 by the end of the second year, but your asset’s value went from $100,000 to $49,000. That’s an indirect cost that needs to be accounted for.
Optimize your cash flow and your entire financial operations
Managing deprecation or your overall cash flow occurrences doesn’t need to be hard. With advanced technology, platforms like Melio make it easy to streamline workflows, amplify cash flow, plus pay and get paid the way you prefer.
All this and more is available in one tool that helps you maximize your business potential: check it out here.
*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.
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