Depreciation & Free Cash Flow: The Noncash Expense Impact

Depreciation, at first glance, can seem a bit puzzling. It’s called an expense, but no money actually leaves your bank account when you record it. So how does this noncash expense impact something as real as a project’s free cash flow? Let’s break it down.

Imagine you’re starting a small coffee shop. You need to buy an espresso machine, right? That machine is a significant investment, let’s say it costs ten thousand dollars. Now, in the real world, that espresso machine isn’t going to last forever. Over time, it will wear out, become outdated, or simply need replacing. Accountants recognize this reality through depreciation. Depreciation is essentially a way of spreading out the cost of that espresso machine, or any long-term asset, over its useful life. Instead of expensing the entire ten thousand dollars the year you buy it, you spread that cost out, perhaps over five or ten years.

Think of it like this: you’re buying a big bag of coffee beans that will last you for a month. You don’t count the whole bag as an expense on the first day. You expense the coffee beans as you use them, day by day, as they contribute to your daily coffee sales. Depreciation is similar but for bigger, longer-lasting assets. It’s about matching the cost of an asset to the revenue it helps generate over time.

Now, let’s talk about free cash flow. Free cash flow is essentially the cash a project or business generates that’s truly free to be used for other things, like paying back debt, reinvesting in growth, or distributing to owners. It’s a critical measure of financial health and project viability. We calculate free cash flow typically starting with net income, which is your profit after all expenses are deducted.

Here’s where depreciation comes back into the picture. Depreciation, as we discussed, is an expense that reduces your net income. It appears on your income statement and lowers your profit figure. However, remember, it’s a noncash expense. No actual cash was spent when you recorded depreciation. It’s just an accounting adjustment to reflect the wearing down of your espresso machine.

Because depreciation reduces net income but doesn’t involve an outflow of cash, we need to add it back when calculating free cash flow. Think of it this way: net income has been artificially lowered by this noncash depreciation expense. To get to the true cash picture, we need to reverse the effect of that noncash item. So, in the formula for free cash flow, often you will see depreciation added back to net income.

Let’s consider a simplified example. Imagine your coffee shop has revenue of fifty thousand dollars and operating expenses, excluding depreciation, of thirty thousand dollars. Let’s say your depreciation expense for the year on the espresso machine is one thousand dollars.

Your net income would be fifty thousand dollars revenue minus thirty thousand dollars operating expenses minus one thousand dollars depreciation, equaling nineteen thousand dollars.

However, your cash flow from operations, before considering capital expenditures and other factors, would be closer to twenty thousand dollars. Why? Because that one thousand dollar depreciation expense, while reducing your net income to nineteen thousand dollars, didn’t actually take any cash out of your pocket. To get a clearer picture of the cash the business actually generated, we add back that depreciation.

Therefore, while depreciation reduces reported profit or net income, it actually increases free cash flow. It’s a subtle but crucial point. It’s a noncash charge that lowers the accounting profit but doesn’t impact the actual cash generated by the project. By adding it back, we get a more accurate view of the project’s cash-generating ability, which is what free cash flow is all about. So, depreciation, though a noncash expense, plays a vital role in the free cash flow calculation, ultimately providing a more realistic picture of a project’s financial performance.