What Is Depreciation?
Depreciation allocates the cost of a long-lived physical asset across the years it helps generate revenue. Instead of expensing a $10 million factory in the year it is built, a company records a portion of that cost as an expense each year of the factory's useful life.
This follows the matching principle of accrual accounting: expenses should be recognized in the same periods as the revenue they help produce. The cash left the building when the asset was purchased, so depreciation itself involves no cash outflow.
How It Works
The simplest approach is straight-line depreciation: Annual Depreciation = (Purchase Cost - Salvage Value) / Useful Life. Accelerated methods front-load the expense into earlier years, which companies often use for tax purposes to defer cash taxes.
On the balance sheet, accumulated depreciation reduces the carrying value of property, plant, and equipment over time. On the cash flow statement, depreciation is added back to net income in the operating section because it reduced profit without using cash.
Example
A delivery company buys a truck for $60,000, expects it to last 5 years, and assumes a $10,000 salvage value. Straight-line depreciation is ($60,000 - $10,000) / 5 = $10,000 per year. Each year the income statement shows a $10,000 expense while the truck's book value falls by the same amount, even though no cash changes hands.
Why It Matters
Depreciation is why EBITDA and net income can tell very different stories, especially for capital-intensive businesses, and it creates a tax shield since it lowers taxable income. In a DCF, depreciation is added back to earnings but must be weighed against ongoing CapEx.
It is also the star of the most common three-statement interview question: walking through what happens across the statements when depreciation increases by $10.
