Depreciation is a non-cash expense that reflects the gradual reduction in value of an asset over time. When companies prepare their financial statements, they deduct depreciation from their revenues, which lowers their taxable income. However, since depreciation does not involve an actual cash payment, it gets added back to net income when evaluating cash flow.
The reasoning behind this is simple: while depreciation reduces the accounting profit, it does not impact the company’s cash position. By adding it back, analysts and investors can get a clearer picture of the company’s operational cash flow. This adjustment allows stakeholders to assess how much cash the company is actually generating from its operations, excluding accounting factors that do not affect cash.
In summary, adding back depreciation provides a more accurate view of cash flow, which is essential for analyzing a company’s financial health and its ability to invest in growth or pay dividends.