Is Depreciation a Source of Funds
Depreciation is not a direct source of funds because it does not bring in cash on its own. However, it’s considered a source of funds in the sense that it’s a non-cash expense that can reduce the amount of taxable income a business reports, which in turn can decrease the amount of taxes a business has to pay. This could increase the amount of cash a business has on hand indirectly.
Depreciation is an accounting expense that allows businesses to spread the cost of an asset over its useful life. Even though it’s an expense on the income statement, it’s a non-cash charge, meaning it decreases net income but doesn’t involve an actual cash outlay.
As a result, when a company calculates its cash flows from operations (a part of the Statement of Cash Flows), it adds back the depreciation expense to net income, because it was a non-cash charge that reduced net income but did not impact cash.
So, while depreciation itself is not a source of cash, it can potentially improve a company’s cash flow position by reducing taxable income and thus taxes paid, and because it’s added back when calculating cash flows from operations.
Example of: Is Depreciation a Source of Funds
Let’s look at an example to illustrate how depreciation is considered in cash flows.
Let’s say a company purchases machinery for $100,000. This machinery has a useful life of 10 years and no salvage value at the end of its life. Using the straight-line depreciation method, the company will depreciate the machinery by $10,000 each year for 10 years.
Now, on the income statement, this annual $10,000 depreciation expense will reduce the company’s net income, and hence its taxable income. Suppose the company’s tax rate is 30%. So, the depreciation expense can reduce the company’s tax bill by $3,000 each year ($10,000 * 30%).
While the company does not receive a direct inflow of cash from the depreciation expense, it does indirectly benefit from the tax savings. So in this sense, it can be said that depreciation is a source of funds, though it’s more accurate to say that depreciation is a non-cash charge that can improve a company’s cash flow position by reducing taxes.
Moreover, when the company prepares its cash flow statement, it starts with net income and then adds back the $10,000 depreciation expense under the operating activities section. This is because the depreciation reduced net income on the income statement but did not result in an actual cash outflow. Thus, adding it back reflects that the company’s cash position is $10,000 higher than what the net income figure would suggest.
So, while depreciation itself isn’t a direct source of cash, it does affect cash flow and can indirectly improve a company’s cash position.
