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Will depreciation affect Cash flow?
Yes, depreciation does affect cash flow, but indirectly. Here’s an insightful look into this relationship:
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Nature of Depreciation: Depreciation is a non-cash expense. It represents the wear and tear of tangible assets like machinery or buildings over time. Since no actual cash is spent when depreciation is recorded, it does not directly reduce the cash balance.
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Tax Implications: The indirect effect of depreciation comes into play through tax savings. Depreciation reduces taxable income since taxes are a cash expense; lower taxable income due to depreciation results in lower tax payments, effectively increasing a business’s cash flow.
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Cash Flow Statements: On a cash flow statement, the effect of depreciation is adjusted for in the operating activities section. Since depreciation is a non-cash expense deducted from net income on the income statement, it’s added back to net income in the cash flow statement. This adjustment reflects the fact that depreciation did not use up any cash.
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Investment and Financing Decisions: Businesses often consider the tax shield benefits of depreciation when making investment decisions. Assets with higher depreciation can offer more tax savings, improving cash flow. This consideration is crucial in capital budgeting and financing decisions.
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Impact on EBITDA: Earnings before interest, taxes, depreciation, and amortization (EBITDA) are often used to evaluate a company’s operating performance. Since depreciation is excluded from EBITDA, this metric gives a clearer picture of a company’s operational cash flow before the impact of non-cash expenses like depreciation.
In summary, while depreciation is not a cash outlay, its impact on reducing taxable income indirectly improves a company’s cash flow by lowering its tax liability. This indirect effect makes depreciation a significant factor in financial planning and analysis.
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