Most companies purchase and use equipment that deteriorates over time. To account for the value of these assets, businesses report depreciation expenses -- a portion of the asset's value that represents how much it has deteriorated. Depreciation expenses are listed on the income statement but on not the cash flow statement, and this sometimes confuses potential investors. Investors should examine both statements, plus the free cash flow statement if it is available, to understand how depreciation expenses affect a business.
Depreciation expenses should be listed on the income statement, not on the cash flow statement. Depreciation affects the business's net revenue and expenses, but it doesn't affect the cash flow. The company doesn't spend any actual money because of depreciation expenses, so there's no need to list it on the cash flow statement. Accountants usually adjust cash flow statements by adding back amounts taken out of net income for depreciation.
When you purchase new equipment for your company, list the entire purchase price on the cash flow statement for that year. The purchase price of the equipment should equal your total depreciation on your income statement after the last year of depreciation. For example, if you purchase equipment for $15,000 and depreciate it over five years, list $3,000 each year on your income statement as a depreciation expense, so that the total depreciation after five years equals the total purchase price.
Selling the Business
If you sell a business, it might appear to be worth more than it is because depreciation is not listed on the cash flow statement. Show potential buyers the cash flow statement from the year you bought the equipment, as well as the income statements from the years of depreciation, so that they know how much the business is actually worth.
Free Cash Flow
Free cash flow, or the cash flow from operations minus capital expenditures, is another way to measure the business's financial health. Depreciation costs would be listed each year as a capital expenditure. Thus, unlike ordinary cash flow, free cash flow is affected on a yearly basis by depreciation. Investors can examine the free cash flow statements to get a clearer picture of a company's finances.
- Hemera Technologies/Photos.com/Getty Images