How does depreciation affect cash flow?

While depreciation doesn't directly impact the cash flow generated by businesses, it is tax-deductible and reduces cash outflows relating to income taxes. Depreciation is categorized as a "non-cash expense" because it's simply an ongoing charge for a fixed asset that diminishes over time to remain in line with the condition/life of the asset, often due to wear and tear.

When companies prepare income tax returns, they list depreciation as an expense and reduce the taxable income reported. If depreciation is an allowable expense to calculate taxable income, it lowers the amount of tax that a company must pay. Therefore, depreciation affects cash flow by reducing the expense a business must pay in income taxes.

This tax effect of depreciation can also increase if the government allows your business to use "accelerated depreciation" to increase the amount you claim as a taxable expense. This further reduces the cash outflow for tax payments for a short period. However, this does leave less depreciation available to claim later on, reducing the favorable tax effect in those periods).

When you create a budget for cash flow, depreciation tends to be listed as a reduction from expenses, implying it has no impact on cash flows. Regardless, depreciation does indeed have an indirect influence on cash flow.

While depreciation does not involve an actual outflow of cash, it does impact cash flow in two ways:

• Taxes. Depreciation is a tax-deductible expense, which means that it reduces the amount of taxable income that a company has to report. This can help reduce the company's tax liability, which in turn increases its cash flow.

• Capital Expenditures. When a company depreciates an asset, it is essentially setting aside funds to replace that asset in the future. These funds can be used to finance future capital expenditures, which can help improve the company's cash flow by reducing the need for external financing.

Overall, while depreciation does not have a direct impact on a company's cash flow, it can have important indirect effects on taxes and capital expenditures, which can ultimately impact the company's ability to generate cash and invest in future growth.