Evaluating How $10 of Depreciation Flows Through the 3 Financial Statements

Depreciation is a non-cash expense that reflects the wear and tear of fixed assets over time, but its impact ripples through all three financial statements: the income statement, balance sheet, and cash flow statement. Understanding this flow is a common technical question in finance interviews, particularly for investment banking and private equity roles. Let’s break down how a $10 depreciation expense affects each statement.

Impact on the Income Statement

Depreciation starts on the income statement as an operating expense. Suppose a company records $10 of depreciation:

• Operating Expenses: The $10 is added to operating expenses, reducing EBIT (Earnings Before Interest and Taxes) by $10.
• Net Income: Assuming a 30% tax rate, the $10 depreciation expense reduces taxable income by $10, saving $3 in taxes ($10 × 30%). Net income decreases by $7 ($10 - $3).

Depreciation lowers net income but doesn’t affect cash directly since it’s a non-cash expense. This tax shield (the $3 savings) is a key benefit of depreciation.

Impact on the Balance Sheet

The balance sheet reflects the asset’s depreciation and the change in retained earnings from the income statement:

• Fixed Assets: The $10 depreciation is subtracted from the book value of the asset (e.g., Property, Plant, and Equipment), reducing total assets by $10.
• Retained Earnings: Net income (reduced by $7 due to depreciation) flows into retained earnings, decreasing shareholders’ equity by $7.
• Balancing the Equation: Assets decrease by $10, while liabilities remain unchanged. Equity decreases by $7, and the remaining $3 difference (the tax shield) is reflected in a deferred tax liability (DTL) increase of $3, ensuring the balance sheet balances.

The DTL arises because depreciation reduces taxable income now but will reverse in the future when tax depreciation differs from book depreciation.

Impact on the Cash Flow Statement

The cash flow statement adjusts for non-cash expenses and reflects the actual cash impact:

• Operating Cash Flow: Start with net income ($7 lower due to depreciation). Add back the $10 non-cash depreciation expense, increasing operating cash flow by $10. The net effect is a $3 increase in cash flow from operations (the tax shield).
• Investing Cash Flow: No impact, as depreciation doesn’t involve cash outflows for investing activities.
• Financing Cash Flow: No direct impact unless the company uses the extra cash for dividends or debt repayment.

In summary, a $10 depreciation expense reduces net income by $7, decreases the asset’s book value by $10, increases deferred tax liability by $3, and boosts operating cash flow by $3 through the tax shield. Understanding this flow is crucial for financial modeling and analysis.