Certain items are debited to the profit and loss account (or income statement) as an expense but they are not paid out in cash in the same period. The most obvious example of such a non-cash expense is depreciation.
By debiting the amount of depreciation in the income statement, net profit falls, but there is no cash outflow.
To arrive at the correct cash flow on account of profits, we must, therefore, add back non-cash expenses to the figure of net profit disclosed by the income statement.
Another example of a required adjustment is a loss on the sale of a fixed asset. A loss on the sale of a fixed asset is, in fact, a form of additional depreciation.
When a fixed asset is sold at a loss, the cash that comes into the company is less than its book value.
The practice is to show the actual amount of cash received on the sale of a fixed asset as a source of cash.
This means that the amount shown as cash inflow is less than the net reduction in the value of fixed assets.
The way to balance this difference is to show the loss on the sale of a fixed asset as a sort of additional depreciation.
As such, the loss is added back to the amount of net profit (as disclosed by the income statement) to arrive at the correct cash flow generated by operational activities.
Non-cash expenses are the amounts paid for items that do not require money to be taken out of the business. Examples include Depreciation, depletion, amortization, and certain other non-cash expenses such as loss on disposal of Fixed Assets (which is actually additional Depreciation).
Some of the more important ones include Depreciation, bad debts (impairment), and loss on disposal of Fixed Assets.
To arrive at the correct net cash flow from operations we must add back to the net profit as disclosed by the income statement certain non-cash expenses.
Cash expenses are those that require an outflow of cash from the business in order for them to be incurred. Examples of cash expenses include salaries, interest on loans, and taxes.Non-cash expenses are those that do not require an outflow of money in order to be incurred.
Non-cash expenses are included in the period they occurred. For example, a loss on the disposal of an asset that occurred this year is included in the current Cash Flow statement.
About the Author
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
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