Can someone verify that this answer is correct? Why do cash flows increase; I thought that depreciation had no effect on the cash flow statement because it is a non-cash expense.
If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements?
This is a fairly common technical question which attempts to test your understanding of how the three financial statements (income statement, balance sheet, cash flow statement) fit together. Note that you may get some variation of this question (e.g. a number other than $10 or an item other than depreciation). To answer this question, take the 3 statements one at a time.
First, the income statement: depreciation is an expense so operating income (EBIT) declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, the cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. Finally, the balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cashflow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholder’s equity decreased $6.
You may get the follow-up question: If depreciation is non-cash, explain how this transaction caused cash to increase $4. The answer is that because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense.
The answer is correct. The cash increase comes from the tax shield on depreciation.
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