Can someone ELI5 on why Depreciation and Amortization are added in the Cash Flow Statement?
Doing something investment banking prep and for the question of "What happens when depreciation goes up by $10" I don't get why depreciation and amortization are added back to the cash flow statement? Doesn't that increase net change in cash?
Okay so basically, you are adding it back to reflect that you didn’t actually lose any cash.
Typically, you start in the IS and if you had 10 dollars of depreciation it is counted as a loss or negative to pre-tax income, which can change your overall net income (ex: you had 10 dollars depreciation on 100 income so now you have 90 pre tax income and with a 20% tax rate you are paying 18 in taxes instead of the 20 you would pay with no depreciation.)
The reason you add it back is because you didn’t actually lose 10 dollars — depreciation and amortization are basically imaginary, and just a symbol to indicate you are using up tangible and intangible assets and they are losing their initial value. But you don’t actually spend or lose any cash.
Therefore, you add it back on the cash flow statement to reflect you still kept all that cash. Then, the final net change in cash will reflect the tax-added dollars of depreciation.
So in the case of 10 dollars depreciation with a 20% tax rate, your net change in cash is 2 dollars, because you technically paid 2 dollars less in cash than you would’ve if you didn’t have depreciation, so you are actually are saving 2 dollars in cash and therefore reflect it on the cash flow statement by adding it back instead of just leaving it as a -8 from the net income in the IS as you didn’t lose any cash at all from D&A.
Does that make sense?
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Depreciation and amortization are non cash expenses. When going from net income to cash flow, you need to adjust non cash items that reduced net income. You add it back because it was not a cash outflow. The goal is to arrive at the net change in cash over a period.
It's like if your house value falls, you're not actually losing money from your savings account
That is a very helpful analogy thanks!
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