Eli5: Why do a depreciating asset increase in the cash flow even though it is an expense?
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Because it was first taken out to calculate net income.
If you use a machine that costs 100 and that needs to be replaced after 10 years then every year 10 gets subtracted from your income to account for the cost of the machine.
When calculating cash flow you start with net income and add back the costs that were not literal cash payments.
A depreciating asset doesn’t affect cash flow. But if you are looking at a company’s books, you might see that they have made a loss of 10K. Digging deeper, you see that the have had depreciation of 100K but no capital purchases. That depreciation didn’t affect their cash flow, although it did affect their profit. This means that despite the 10,000 dollar loss, their cash situation has improved by 90K.
So in order to understand the company’s cash situation, you have to look at both profit, capital expenses, and depreciation.
If we’re talking about real estate, depreciation and appreciation can happen at the same time, and both are good for the owner.
Depreciation in commercial real estate gives an amount of revenue that is tax free because things need to be replaced and the money has to come from somewhere.
I think a more simple way to think about it is this:
When you purchase a piece of equipment, you pay out the full value of it immediately in cash, which is shown as an investing activity on the cash flow statement. If you counted depreciation expense as a cash output as well, by the end of the asset’s useful life you would be saying your cash decreased 2x what you actually paid.
Essentially the cash output is already shown in full in investing activities, so you don’t show it again in operating activities.
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