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## Finance and capital markets

### Unit 5: Lesson 3

Depreciation and amortization

# Depreciation in cash flow

Depreciation in Cash Flow. Created by Sal Khan.

## Want to join the conversation?

• I don’t understand why one adds back Depreciation to the Cash from Operations in the Cash Flow Statement as a positive value. The truck didn’t give u back \$20 to put in your pocket each year. Doing this feels like you just got a free truck.
(55 votes)
• I was momentarily taken aback as well, and then suddenly remembered that it was a cash flow statement, not and income statement I was looking at. The table at the top is a very simplified income statement, so the depreciation expenses would reduce your operating profit. In the cash flow, however, you are essentially spinning this around to focus on the cash side. Your profit was \$30K (\$100K - \$50K - \$20K), so that cash comes in. But while depreciation is an expense, it is not a cash expense. (In other words, you didn't spend \$20K out of the net new \$50K added to the checking account over the year.) So, to recognize the \$50K as "Cash from Operations", you have to add that \$20K back to the net profit to balance to that \$50K in cash received. Note that there was a capital expenditure which "burned" the \$60K you started the year with. So, you started with \$60K, but bought the truck (leaving you with \$0), then brought in \$100K in revenue, while paying out \$50K in labour (leaving you \$50K in the bank). Depreciation affects profit/loss numbers, but not cash (the capital expense, however, does). Hope I explained this in an understandable form.
(119 votes)
• wouldn't it make the most sense to think of it in this order:
Cash from Ops: \$50k
Depreciation: \$20k
Profit: \$30k (= Cash - Depreciation)
(9 votes)
• I hope this will answer your question, but if not please feel free to expound upon your query, and hopefully I can be of assistance.
On the Income Statement, you want to list your income (Revenue) and all operating expenses to come up with a profit figure on which you pay taxes. Here, you want to list depreciation as one of those expenses (though it's not actually paid) so that your reportable profit is lower. This enables you to pay less in taxes. It's also easier to use this format for other calculations, as you are often interested in: EBIT (Earnings Before Interest and Taxes) which is a measure of accounting profits, and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) which is a measure of actual cash flow. The latter is useful for financial analysis purposes, particularly in evaluating new investment opportunities.
On the Statement of Cash Flows, you already have numbers calculated on the Income Statement, so to reduce redundant calculation you just list the operating profit (EBIT) and add back in depreciation to come up with the actual cash from operations (EBITDA).
(18 votes)
• I still don't understand why the \$20 depreciation is added in the cash flow statement. Can someone please explain?
(6 votes)
• why not just not include depreciation at all in the cash flow statement. depreciation and amortization have nothing to do with cash changing hands.
(2 votes)
• They are not "included" in the cash flow statement, but if you start with net income to generate your cash flow statement, then you have to add them back to take them out.
(4 votes)
• I don't understand why the depreciation has to be added back at all. One way I looked at it was as using the truck meant 20k of its value is infused to your business during operation. but here again it is not profit. if we don't add the 20k back, the cash from operations and operating profits are both 30k and match. why should we add it back? Someone please explain this to me. I went through the comments still didn't get a proper sense of it.
(3 votes)
• I don't know if this will answer your question but if I'm not wrong, the 20k is added to the cash account because what you are doing is investing in a truck, that is, you are not losing money, the only thing you are doing is transforming those 60k (cash) into an asset (a truck, which is despised "loses its value") so this in itself is not taken as a loss, and on the other hand that 20k is added as profit because your cash is not really coming out of anywhere, that is, you are not paying 20k every year, you only paid 60k one year and that's it, but in the stable account table you put it in negative numbers (you subtract it) because this way your profits are shown in a more consistent way. Maybe it just makes things more complicated for you hahaha, but I hope this helps you.
(2 votes)
• If I recall correctly, the reason that we have to add back the depreciation expense is because we wanted to make the income statement look steadier, to more accurately reflect the steadiness of the business. It is my understanding that there are several other non-cash transactions that are often included on an income statement. I imagine that this begins to complicate things increasingly. So, my question is this: Is all of the trouble worth making an income statement LOOK steady? Would it not be simpler for income statements to specify the expenses that cause operating profit volatility?

Lastly, what would Khan recommend as the next step in this learning process, for one who wants to get more advanced and learn to read and understand REAL financial statements?

Thank you for your work.
(2 votes)
• Here matching principle is being employed. Allocating the cost over the useful life of an asset. And it is apt to say that employing this method is to give a good reflection of the company's ability to make a profit.
(1 vote)
• This was so confusing, but here's how it clicked for me:

The \$30k profit in the cashflow statement is "wrong" because it assumes that the truck has been an operating cost, as written in the income statement at the top. The true net operating income is \$50k. That is why the \$20k is added back in the cashflow statement, to show that the business didn't really lose those \$20k in any of those months, it only lost \$60k in the first of each group of three months.
(2 votes)
• At , I understand why you are going to add the 2nd and 3rd year. But why the first year do we add 20K the first year. Even if we didn't use the full value of the truck in the first year and we are going to split up the expense between the 3 years. Why the first year do we add? And if anything you should say the first year we add 40k 2nd year 20k and last year none.
(1 vote)
• You add whatever was subtracted as an expense to arrive at net income.
If you bought it at the beginning of the first year, you used up some it during that year, and that's an expense but it is a not cash expense.
(3 votes)
• If we paid for the truck upfront at \$60k, why would we be adding 20k back each month for depreciation? I understand if we spread this cost out and it was \$20k per year, but this make it seem like the total cost of the truck, plus a \$20k expense each year. Are we saying that the truck's value stays the same and we get \$20k back each year?
(1 vote)
• No one has satisfactorily explained why depreciation is added to profit in the cash flow statement. An excerpt from another site to contextualise my question.

I found this, "Even though depreciation is a legitimate expense and must be recognized, it is not a cash outlay. Therefore, the cash position of the company must be greater by that amount than is indicated by the profitability figure alone." [source: http://smallbusiness.chron.com/happens-depreciation-not-added-back-cash-flow-48904.html]

Now my question is - since depreciation is not a cash outlay it should not reflect negatively in the cashflow statement, why does it then have a positive effect on cashflow? (in my mind it should just be left out)

When i think of cash, i think of the physical asset, i.e. 30k in my hands. How does adding depreciation to profit place 20k more of physical cash in my hands?

Am i thinking about cash incorrectly?

I'm sure there is an explanation out there that will make my brain click but i've read all the comments and read articles on a bunch of different websites and every explanation boils down to "it is not a cash outlay so it should be added to profit" or "to balance the capex effect on the cash flow statement" neither of which goes far enough to explain the reason to add this to profit in the cashflow statement.
(1 vote)
• Depreciation was not a cash expense, but it was subtracted from revenue in order to calculate profit. So if you want to calculate what the cash flow was by starting with profit, you have to add it back.

The key is that you are starting from profit and working backwards.

You could also calculate cash flow by starting from revenue and working forward. Then you wouldn't subtract depreciation in the first place, so the number you come up with for "cash profit" would be higher than your correct accounting profit.

When working backward from profit, first you add back the depreciation that was a non-cash expense that was subtracted from revenue, but then in exchange you have to subtract out capital expenditures, which was a cash expense that was NOT subtracted from revenue to come up with profit.

So if cap ex equals depreciation, the cash flow will be the same as the net income (if there are no other adjustments).
(1 vote)

## Video transcript

Let's see if we can better understand what a cash flow statement for my simplified shipping truck example company would actually look like. Now I say it's simplified because this is a very simplified income statement for each of these periods. I'm not really showing all the expenses or all of the details that you would actually have for a shipping company but we really just care about the accounting. So let'a just say that at the beginning of this fiscal year, when I started this company, I had \$60,000. We know from our example that we used that \$60,000 to buy a \$60,000 truck. And on the cash flow statement you express that saying "I spent \$60,000 on Capital Expenditure" sometimes it's "property plant and equipment". So you would actually put the \$60,000 right over here, on capital expenditures. and hopefully we'll understand this in a little bit Now remember, the cash flow statement is really a way of reconciling the profit with the starting and the ending cash. So let's just think about this a little bit. Our profit here, if we just take the number that we have here, Our profit in the first period is \$30,000. We're assuming nothing shady is happening with the Accounts Payable, Accounts Receivable, that they're not changing over the course of the year. And then we have depreciation, and we want to think a little bit in this video, what does the depreciation do to the cash flow statement? So I'll just write down the number first. So we have this depreciation value. This is the truck depreciation. It's not just the expent value of the truck, we're spreading that cost over 3 years. So \$20,000 over 3 years is the life of that truck. So the depreciation in each of these periods is \$20,000. And what I'm going to show you here is, To figure out the cash from operations from actually how much cash the operations are producing. We want to add back this depreciation to the profit so our cash from operations is going to be \$50,000. And it might not seem obvious to you at first, but I want you to think about it. This \$20,000 that we're showing as an expense in every period, and it actually might be more obvious if we think about period 2 or period 3 We're showing it as an expense but \$20,000 did not go out of the door in year 2, or year 3. We're just showing some of the expense from previous years. So no cash went out of the door. So in any of these periods, the depreciation expense should be added back to the operating profit, to figure out the cash from operations. And you might say "Wait! But we spent that \$60,000, especially in year 1" And that goes here, under Capital Expenditures. The operations didn't push that cash up, the business itself, this is just an investment that we made. So it all works out, because what we see is that we got \$50,000 cash from operations, and that makes sense because our revenue was \$100,000 just the labor, the cash labor, people's salaries, were \$50,000 So that's \$50,000 of profit. This was not a cash expense, so from our operations we had \$50,000 dollars, But then we did have the capital expenditures of \$60,000 for the actual truck. So our ending cash would be \$60,000+\$50,000-\$60,000. So our ending cash is going to be \$50,000 Now it might make a little bit more sense if we go to the next period. Our starting cash here is \$50,000. It's our ending cash of the previous period. Our profit, once again, is \$30,000. You add the profit to the depreciation, you get a \$50,000 operating profit same as the previous year. Or I should say cash form operations, and that makes sense, because our operations really haven't changed. We have a very, very steady business. But this year, I have no capital expenditures. So I'm using the same truck as last year. So now Our ending cash: Our starting cash was \$50,000, we had \$50,000 from operations, now our ending cash is \$100,000. So hopefully that gives you a sense of why we add back depreciation when we figure out the cash from operations and how it works out in our cashflow statement.