Depreciation & Taxes

In the cash flow estimation, the effect of depreciation & taxes makes lot of difference. The computation of after-tax cash flows requires careful treatment of non-cash expenses items such as depreciation. Depreciation is an allocation of cost of an asset. It involves accounting entry and does not require any cash outflow, the cash outflow occurs when the assets were acquired.

Depreciation (as per income tax rules) is however deductible for computation of taxes. Indirectly it influences the cash flow, since reduces the firm’s tax liability. Cash outflows for tax saved is in fact an inflow of cash. The savings resulting from depreciation is called depreciation tax shield. Depreciation is a non-cash item and should be added to profit to compute actual cash flows.

Because depreciation is added back to net income to get the cash generated from operations, financial analysts sometimes mistakenly refer to depreciation as a source of cash. If depreciation were a source of cash, a change to a more rapid depreciation method would cause the cash balance to go up. But, that will not happen. The addition of depreciation in the cash flow statement is simply a way of adding back an amount that was deducted from income but did not use cash. Depreciation is neither a source nor a use of cash.