Instructor Blog - Five Cs of Credit

Q: Why is cash flow calculated as net income plus depreciation expense? I'm struggling to understand why depreciation expense isn't subtracted from net income. (See Slide 23)

A: Even though the cash impact of an asset purchase occurs in the year it is purchased, the asset is typically depreciated over its useful life on a company’s accrual financial statements in accordance with Generally Accepted Accounting Principles (GAAP). The amount of depreciation per year is recorded as an expense against income each year. Therefore, net income reflects income after all expenses allowed under GAAP, including depreciation expense, have been deducted.

Depreciation expense represents an allocation of the cost of an asset and is a non-cash event.  Cash flow is the calculation of cash that is available to service debt. Since depreciation is a non-cash event and has been deducted as an expense before arriving at net income, it must be added back. Otherwise cash flow would be understated by this amount. The same is true for any other non-cash expense allocation, e.g. amortization expense or depletion.