Profit and cash flow are the two figures that are normally outstanding when you look at the financial performance of a company. They can appear at first sight to be similar methods of quantifying the same thing. However, they are different stories. The difference between them is usually narrowed to one accounting principle: depreciation.
The knowledge of the depreciation process, and more so, the impact of depreciation rates on your financial statements, can fundamentally alter your perception of the health of a business. It makes a difference whether you operate a company, invest in one, or handle finances.
What is Profit?
Profit, also known as net income, is what a business has left after deducting all the expenses incurred by the business from its revenue. This consists of operating expenses, salaries, rent, interest, taxes, and non-cash items such as depreciation.
Profit is on paper used to show the performance of a company in a certain period of time. It is a direct question: Did the company make more than it had to spend?
But here’s the catch. Profit is calculated upon accounting principles, rather than the actual cash in and out of the bank account.
What is Cash Flow?
Cash flow is the flow of cash in and out of a business. It is concerned with the liquidity, the amount of money that the company actually has to deal with bills and reinvest, or pay owners.
A firm may make a profit and yet run out of cash. Conversely, it may record low profit with high cash flow.
This is where depreciation begins to reconstruct the story.
What is Depreciation?
Depreciation allocates the cost of a long-term asset during its useful life. Businesses do not include the entire cost of equipment, vehicles, or machinery in the current year of purchase, but instead expense the cost over time.
To illustrate, when an organisation purchases a machine whose cost is 100,000 USD and its useful life is 10 years, it can record depreciation expense of 10,000/year based on the rates of depreciation applying.
The important point is as follows: depreciation is a non-cash expense. The equipment was already financed by the company. The annual depreciation cost does not imply extra cash out of the business.
The Effect of Depreciation on Profit
Since depreciation is treated as an expense, it decreases profit.
Based on the above example, the depreciation cost of 10,000 each year reduces net income in the year. Profit appears smaller on paper.
Here, the rates of depreciation come in. Various approaches, including straight-line or accelerated depreciation, apply varying depreciation rates. Increased depreciation implies increased annual costs, which increases the reported profit at a higher rate of the initial years of the life of an asset.
Thus, two companies with the same equipment and also the same revenue might record very different profits just because they use different depreciation rates.
Both could be accurate in an accounting sense. However, their narrative to investors can appear quite different.
The Effect of Depreciation on Cash Flow
Now let’s look at cash flow.
Depreciation is non-cash and, therefore, does not decrease cash directly. The cash had already been used at the point when the asset was acquired.
Indeed, in the indirect method of computing cash flow of operations, depreciation is included in net income. Why? Since it decreased profit without decreasing cash.
This implies that a company might report small profits because there is a high rate of depreciation, yet produce high cash flow.
This distinction is misinterpreted. The reduction in net income due to increased depreciation rates does not necessarily imply poor financial health. In a lot of cases, it is merely accounting timing.
A Real-World Scenario
Take the example of two construction firms. They both buy heavy equipment worth 500,000.
Company A applies aggressive depreciation rates and expends a significant amount of the asset cost during the initial few years. Company B has a more conservative depreciation rate, and it splits the cost over a greater length.
In year one:
- The company A records a lesser profit because of an excess depreciation cost.
- Company B depicts more profit due to the lower depreciation expense.
But they all paid the same amount of cash in advance, which was $500,000. Their real cash positions can be almost exactly similar.
At first glance, you might think that Company B is doing better because of its profit. However, when you look at cash flow, it is a different story.
The Importance of Depreciation Rates to Investors and Owners
Depreciation rates affect:
- Reported earnings
- Tax liability
- Asset book value
- Financial ratios
Accelerated depreciation minimises the taxable income sooner, and it may enhance the short-term cash flow by decreasing tax payments. The slower rates of depreciation smooth earnings.
It is important to investors when they are analysing measures such as earnings per share or returns on assets. A company whose depreciation rates are high can not seem profitable, though its underlying operations might be good.
Depreciation rates will assist business owners in strategic planning. Even when your cash flow is not changing, you can report a decline in profit in the short term, even when you are investing heavily in equipment.
Profit vs Cash Flow: Which One to Trust?
The honest answer is both.
Profit is long-term, sustainable. Cash flow indicates immediate survival.
When a business makes a constant profit and has difficulties in getting cash flow, it can have a liquidity issue. It might just be in a growth stage with a high rate of asset depreciation, as demonstrated by positive cash flow, but a reduction in profit.
The trick is to know why the figures are different.
The Bottom Line
Depreciation alters the tale of your financial statements. It reduces profit but does not influence cash in the same direction, as it is a non-cash expense. The rates selected to depreciate assets show the rate at which the cost of assets is depreciated to report earnings.
Don’t end on net income when you are analysing any business. Look at cash flow. Check on the depreciation rates being applied. Know how the assets are being written off.
When you do, you will find that profit and cash flow are not opposing figures. They are complementary bits of a larger financial picture.
And in that shot, depreciation is a silent element that can make all the difference.
