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Depreciation and amortization on the cash flow statement adds back non-cash charges to net income. It is typically the largest adjustment when calculating operating cash flow.
Depreciation and amortisation (D&A) represent the systematic allocation of asset costs over their useful lives. Depreciation applies to tangible assets like buildings, equipment, and vehicles, while amortisation applies to intangible assets like patents, software, and acquired customer relationships. These non-cash expenses reduce reported income but don't consume actual cash in the current period.
The purpose of D&A:
- Matching principle: Spreads asset cost over periods benefiting from the asset
- Tax deduction: Reduces taxable income, creating tax shield benefits
- Capital recovery: Recognises the consumption of productive assets
- True profitability: Accounts for the real cost of using capital assets
Common depreciation methods:
- Straight-line: Equal annual amounts over useful life
- Declining balance: Accelerated; higher expense in early years
- Units of production: Based on actual usage or output
Example calculation (straight-line):
Asset cost: $100,000 Salvage value: $10,000 Useful life: 10 years Annual depreciation: ($100,000 - $10,000) / 10 = $9,000
Why D&A matters for cash flow:
- Non-cash add-back: Added back to net income when calculating operating cash flow
- EBITDA component: D&A excluded from EBITDA to show operating performance before capital charges
- Tax timing: Accelerated depreciation defers taxes, improving near-term cash flow
Analytical considerations:
- Capital intensity: High D&A indicates asset-heavy business model
- Maintenance capex: D&A approximates (imperfectly) required capital reinvestment
- Acquisition effects: Acquired intangibles create ongoing amortisation charges
- Impairment risk: Assets may require write-downs beyond normal D&A
D&A is a real economic cost—assets do wear out and must be replaced. While it's non-cash in any given period, ignoring D&A overstates the sustainable cash a business generates. Compare D&A to actual capital expenditures: if capex consistently exceeds D&A, the company is growing; if D&A exceeds capex, assets are aging without adequate reinvestment.