Depreciation Cashflow (Technical Interview Question)
Hello - I had a question on the standard "walk me through $10 of deprecation for each of the financial statements" question.
Assuming a 20% tax rate. I know that we would have,
IS: Net Income down by 8 CFS: Cash Up by 2 (Net Income Down by 8, add 10 of depreciation back) BS: Cash Up by 2, PPE down by 10, Retained Earnings down by 8
My question is - why does cash go up by 2? I understand that we add back depreciation to the CFS and that the positive 2 we add to cash represents the tax break for the depreciation expense, but unlike paying taxes, where we definitely lose cash, we don't actually receive cash for this tax break unless I'm mistaken. So why would we increase our cash account (assuming that this depreciation expense was the only transaction to happen during the year)?
By adding back depreciation, you are essentially undoing the non-cash or non-operating impacts to your net income, and re-assigning the impacts to different asset accounts (in this case, net PPE). Let's say you had $10 of EBITDA, $10 of depreciation expense, 0 taxes and 0 interest. Your net income would be $0. However, if you only looked at the cash impacts from your true operations (i.e. didn't look at depreciation) your net income would be $10. Basically this adjustment tells us is that the operations of the company generate a cash flow of X, but there are other important balance sheet capital adjustments to consider, as part of running the business (like acc. depreciation, retained earnings). In your example, the $2 is a reflection of the cash generating potential of your business (after tax), undoing all the impacts of non-cash items, non-operating items, and accrual accounting. So even though the company is running a loss, the business is generating cash flow in its operations.
I hope this makes some sense, I know it's a bit confusing.
Thank you! This was all very helpful.. I understand what you said in regard to showing cash flow potenial on the CFS, but then why do we actually add the $2 of cash to the balance sheet?
You add the cash because the "business operations" did in fact generate an after tax cash flow of $2. However, the net effect is -$8 to your assets (after the -$10 of deprecation), and this is balanced by the -$8 of losses in retained earnings (which reflects all impacts to your net income: cash and non-cash).
As I understand the $2 comes from the $2 less paid in taxes.
Income Statement EBT: -10 Net Income= EBT(1-Tax %) = -100.8= -8
CF Net Income: -8 Depreciation: +10 CFFO: +2
BS Cash: +2 PP&E: -10
RE: -8
This. You’re recognizing the $2 in tax savings right away as an increase in cash flow.
An increase in expenses will almost always result in less taxes paid (unless it’s deemed ineligible by IRS and added back to your income on a tax basis), and thus an increase to your cash balance.
It is not that your cash goes up. You book less taxes. Less cash is being subtracted (if it is all cash based)
Every tax expense is booked, like any other expense, against cash or a liability (Taxes payable) is created.
If you have depreciation you book less taxes and as a result either less cash is being suvtractrd or less liability created.
When you reverse, it might be that your cash stays exactly as it was before, as the liability is the one that goes down.
But in this scenario, our cash does actually go up doesn't it? We add 2 to our cash account on the BS.
I think to record the actual tax expense, if we assume that the depreciation is the only transaction during the year, we'd have to debit a DTA and credit GAAP Tax Expense. So cash account isn't touched with journal entries, but it goes up. This is the confusing part for me.
If you did not pay your taxes in cash, there will be no adjustment in cash. In that case you have two non cash entries. Cash cannot change unless you get cash in or pay cash out. As simple as it gets. In that case only the Income Tax Liabiltiy is being adjusted and compensates for the added depreciation and lower net income. Again, cash position does not change. For example: https://www.dropbox.com/s/ikpi87702le1ap8/Depreciation%203st%20Example…
DTA/DTL has nothing to do with that.
don’t think about it as depreciation “creating” cash. more intuitive to think about it as an adjustment to an existing set of financial statements. in a state of the world where you have $10 more of any expense on the IS, your cash, assuming 20% tax rate, would be $2 higher because you’d have paid less tax
Thanks, that makes sense to me, but what I'm asking about is this particular situation where there is no tax, because EBIT is negative.
Depreciation created an EBIT of -10, so there is a tax benefit of 2, and Net Income of -8. No actual cash came in or went out, but we adjust our cash account up when we add back depreciation to the CFS.
Bluegomaize,
If the firm is in an overall loss before depreciation, the depreciation will make the net operating loss (NOL) for tax purposes larger. Here are the outcomes:
If the firm has profits in prior years, they can carry the NOL back for a tax refund, thereby actually generating an increase in cash potentially in that year depending on when they amend the old tax return.
If the firm doesn't carry the NOL back, they will not get an immediate tax savings, and thus no increase to cash should be reflected in the year of loss, but a deferred tax asset should be created for the future tax savings from the NOL they will carry forward. If they do have profit in a future year, they will use the NOL carryfoward and then save actual cash taxes and the NOL deferred tax asset will be either reduced or eliminated.
Hope that helps.
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