Accounting: impact of depreciation of fixed assets on cash flow?

Question

Hello!

I am trying to get a grounding in accounting, and am currently reading a sort of "for dummies" book. But it appears I am too much of a dummy to understand this part...

When writing up the cashflow statement, why do you "add back" depreciation of fixed assets?

Here is the explanation from the text:

"....Depreciation therefore affects operating profit. It does not, however, affect cash. Hence, if all the sales and costs which give rise to the £13k operating profit were cash transactions except the depreciation, then the cash flow during the year would be £3k higher than the operating profit. Hence we 'add back' depreciation."

what!? I don't understand, if a certain component of operating activities does not affect cash flow, then how come it's impact isn't simply NOTHING?

Hope I haven't confused my question too much :/

Thanks for your help! :)

Anonymous · Accepted Answer

I took an introductory accounting class last semester and at first, I didn't understand this too, however I think my explanation should help you out!

Imagine that you run a business and total CASH sales (revenue) were $1,000 for a period.
Depreciation (a non-cash expense) was $200.
There were no other expenses or payments during the period.

From the info above, operating profit is equal to revenues minus expenses.
So, operating profit must be $1,000 - $200 = $800.

However, in this situation, operating profit would not be equivalent to net operating cash flows. Why? Because the operating profit takes into account 'depreciation', a non-cash expense. Therefore, in order to derive net operating CASH flows, depreciation must be added back to operating profit in order to calculate net operating cash flows (since cash flow statements do NOT deal with non-cash expenses such as depreciation, or non-cash revenues for that matter):

Operating profit $800
Add: Depreciation $200
= Net operating cash flows $1,000.

Hope it helps.

P.S. Your book assumes that cash flows will be derived from adding/deducting non-cash expenses and revenues to operating profit.. If you leave operating profit as it is, or do nothing as you put it, that would certainly not result in a correct operating cash flow figure.

Anonymous · Answer

Depreciation is the reduction in value of a fixed asset over time. ... We are going to use the computer for years to come and we accountants think it is fair ... capitalizing method have the same exact effect on cash flow (FYI, the income statement, .

Anonymous · Answer

It seems that Â£3k will need to be set aside for the acquisition of new fixed assets?

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Accounting: impact of depreciation of fixed assets on cash flow?

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