Does Depreciation Affect Cash Flow? A Breakdown for Business Owners
Learn how depreciation shapes your cash flow, taxes, and financial planning.
Key takeaways
- Recognize that depreciation is a non-cash expense, so recording it never moves money out of your account.
- Understand that depreciation affects cash flow indirectly by lowering taxable income and reducing the taxes you owe.
- Apply the added-back rule: depreciation is added back to net income on the cash flow statement to reconcile it with actual operating cash.
- Choose a depreciation method, such as straight line or declining balance, that fits how quickly your asset loses value.
What is depreciation?
Depreciation is the decrease in a physical asset’s value over time, like the factory equipment that produces guitars. It reflects how an asset’s worth keeps dropping as it ages and the more you use it.
You will also see depreciation on your cash flow statement. It gets listed as a non-cash expense across the years you use the asset. This affects your cash flow forecasting, your net income, and even how much tax you pay.
Does depreciation affect cash flow?
Depreciation affects cash flow indirectly, not directly. It is a non-cash expense, so no money leaves your account when you record it. Instead, it lowers your taxable income and gets added back to net income on the cash flow statement.
The IRS lets you deduct part of an asset’s cost each year as depreciation, which lowers your taxable income. Because that reduces the taxes you owe, it helps more cash stay in your business. That is why people often say depreciation can indirectly increase cash flow, even though it never moves cash on its own.
Types of depreciation methods
There are multiple ways for businesses to list and charge depreciation. We’ve gathered some of the most popular ones.
Straight line
Straight line depreciation spreads the cost evenly. A business takes the cost of a machine (say, $100,000) and divides it by the years, quarters, or months it plans to use the machine (say, five years). The same amount gets listed for depreciation in every accounting period, just like a straight line on a graph.
This continues until the asset reaches either zero value or a value that can be recovered, for example by selling the used machine.
Declining balance and double declining balance
Declining balance depreciation front-loads the expense. The straight line method assumes an asset’s value drops gradually and equally over time, while the declining balance method assumes the value drops much faster in the early years of use. That is why some call it the diminishing value method.
The double declining balance method is similar but depreciates assets twice as fast. Assets that become obsolete quickly, like many electronics, are a good fit for this method.
Sum of years’ digits
Sum of years’ digits is another accelerated method. It assumes an asset’s benefit to a business is greatest when it is first used. That benefit declines over the years as the asset gets used. The asset’s impact on cash flow is also greatest when it first goes to work.
Ideally, the business builds the asset into its cash flow recovery strategies and recovers the cost over time. It might even drive profits.
So this method charges the most depreciation in the initial years, in an accelerated way, though not as fast as the declining balance method. Businesses that use it tend to charge the least depreciation in the final year, once most of the investment has been returned.
The distinction between depreciation and cash outflow
Just like the cash flow versus profit confusion, the difference between depreciation and cash outflow takes a moment to understand. Both relate to the cost of doing business. So let’s take a look.
Does money literally go out of your account?
Cash outflow is all the money literally leaving your business account. This includes paychecks, supplies, bills, taxes, business investments, debt payments, and interest. To find your cash outflow for a period, add up all your expenses during that time.
Like cash outflow, depreciation helps create a clearer picture of your business’s financial health. If you bought a machine for $100,000 and it needs replacing in five years when it is worth $15,000, you need to know that.
So why is depreciation a non-cash expense?
Because no money actually leaves your account. The machine is standing in your factory, manufacturing guitars. Depreciation simply records that your asset’s financial worth keeps decreasing over time.
If that is the case, does depreciation go on the income statement?
Which one goes on your income statement?
Both depreciation and cash outflow go on the income statement. There, cash outflow, or expenses, get deducted from overall earnings to find the business’s profits.
But while cash outflow reflects the business’s entire spending, depreciation gets listed as part of the operational expenses.
Example of how depreciation affects cash flow
Let’s say your business manufactures guitars and sells them to stores. If you buy a machine for your factory for $100,000, use it often for five years, and then want to sell it, it will no longer be worth $100,000. You will likely sell it for much less.
Let’s assume your business estimates 30% year-over-year depreciation.
- By the end of the first year, your machine will likely be worth $70,000.
- By the end of the second year, it will likely be worth $49,000.
As mentioned above, the depreciation gets added to the cash flow statement as an operational expense. But why is depreciation added back to cash flow statements if no cash actually goes in or out once the machine is fully paid for?
It is added back because it was subtracted as an expense to calculate net income, even though no cash left the business. Adding it back reconciles net income to the actual operating cash the machine helped generate.
Optimize your cash flow and your entire financial operations
Manage depreciation and cash flow in one place. Platforms like Melio help you streamline workflows, improve cash flow control, and pay or get paid the way you prefer.
All this and more sits in one tool that helps you get the most from your business. Sign up for Melio to get started.
Depreciation and cash flow FAQs
Is depreciation a part of cash flow?
Yes, but not as a cash movement. Depreciation appears on the cash flow statement as a non-cash item that is added back to net income under the indirect method.
Does depreciation affect cash or profit?
Depreciation affects profit, not cash. It lowers reported net income as an expense, yet no cash leaves your account when you record it.
Does depreciation increase cash flow?
Not on its own. It can indirectly help cash flow by lowering your taxable income, which reduces the taxes you pay and leaves more cash in the business.
*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.
How to Pay International Contractors
Pay international contractors quickly and compliantly with the right method, paperwork, and payment platform.
Direct Method Cash Flow Statement: How To Prepare One
Learn how the direct method cash flow statement tracks real cash in and out, and when to use it.
Benefits of Integrating Your Accounting Software with Melio
Discover how accounting software integration syncs your bills and payments, saving time and cutting costly errors.
