If depreciation is a non-cash expense, why does it affect the cash balance?
Answer
Let’s work from EBITDA to Net Income for an example:
EBITDA = $200
D&A = $50
EBIT = $150
Interest = $50
EBT = $100
Taxes = $25
Net Income = $75
Notice that D&A comes before Taxes. The reason that Depreciation affects cash is because it reduces the amount of taxable income (EBT).
Let’s see what happens if we removed depreciation:
EBITDA = $200
D&A = $0
EBIT = $200
Interest = $50
EBT = $150
Taxes = $38
Net Income = $112
Notice how the company paid more taxes this time.
A nice way to answer this is by saying it’s tax deductible and reduces the amount of taxes paid by a company.
Why this matters to bankers
Knowing how to correctly treat Depreciation is key to creating accurate Cash Flow Statements and calculating Free Cash Flow, which is critical for DCFs and LBOs. This is also a question that really pushes you to think about net income and cash through a complete lens. You should always understand how every line item affects those two values.