What it means
Accounting records many costs when they are incurred or allocated, not when cash is paid. Depreciation spreads the cost of an asset over its useful life, even though the cash was spent when the asset was bought.
The depreciation charge lowers profit each year but does not take any cash out of the bank in that year. Other common non-cash items include amortisation of intangible assets, share-based compensation (paying staff in shares or options), impairment charges (write-downs when an asset is worth less than recorded), and changes in deferred tax.
Gains can also be non-cash, such as a revaluation gain on an investment that has not been sold. The cash flow statement exists to deal with these items.
Starting from net profit, it adds back non-cash expenses and removes non-cash gains to arrive at the cash generated by operations. This is known as the indirect method, and it explains why profit and cash flow can look quite different.
For managers, understanding non-cash items prevents two common errors. The first is thinking a profitable business has plenty of cash, when its profit may be mostly accounting entries.
The second is assuming a loss-making business is running out of cash, when large non-cash charges may account for the loss. Analysts often adjust for these items when valuing a business.
Measures such as EBITDA (earnings before interest, tax, depreciation and amortisation) strip out some non-cash charges to focus on operating performance. The risk is that ignoring them entirely hides real costs, since assets must eventually be replaced and share-based pay dilutes owners.
A good habit is to ask of any profit figure what share is cash and what share is accounting. Reading the cash flow statement alongside the income statement answers that question quickly.
It is the simplest way to avoid being misled by headline profit.
In practice
Real-world examples.
Example
A delivery firm buys vans for $300,000 and depreciates them over five years. The income statement shows a depreciation charge of $60,000 each year. No cash leaves the business in those years because the cash was spent when the vans were bought. The firm must still budget for replacement vans when these wear out.
Example
A technology company pays part of its staff costs in share options worth $2,000,000 for the year. Profit falls by that amount, but no cash is paid out. The cash flow statement adds the amount back. Existing shareholders note that their ownership is diluted when the options are exercised.
Example
An investment company holds shares that rise in value by $500,000 during the year without being sold. The gain increases reported profit, but no cash has been received. The cash flow statement deducts it to show real cash generated. The finance team explains the difference in the notes so that readers are not misled.
Formula
Calculation
Cash from operations before working capital changes = net income + non-cash expenses - non-cash gains
A company reports net income of $200,000, depreciation of $50,000 and share-based pay of $20,000. Cash before working capital changes = 200,000 + 50,000 + 20,000 = $270,000. If customers owe $30,000 more than last year, operating cash flow = 270,000 - 30,000 = $240,000.Case study
Seen in the real world.
Birchwood Printing is a fictional company that reported a loss of $100,000 for the year and worried its owners. In this illustrative story, the accountant pointed out that the loss included $180,000 of depreciation and a $40,000 write-down of old equipment. Neither charge involved cash leaving the business that year.
Cash from operations before other changes was therefore -100,000 + 180,000 + 40,000 = $120,000. The owners realised the business was generating cash despite its reported loss, and used the money to repay a bank loan. They also started reviewing the cash flow statement before the income statement at each board meeting.
Birchwood's accountant also warned that the position could not last for ever. The company would need roughly $180,000 a year to replace its machines as they wore out, which is the real cash cost hiding behind the depreciation charge. The owners therefore set aside part of the cash each year, treating depreciation as a guide to future spending rather than as an item to ignore.
Watch out
Common mistakes.
- Treating non-cash items as unimportant. Depreciation reflects the real cost of using assets that will eventually need replacing.
- Assuming profit equals cash. Non-cash items and changes in working capital can create large differences.
- Adding back every item automatically. Only items that did not involve cash in the period should be added back.
Questions
People also ask.
What is the most common non-cash item?
Depreciation, which spreads the cost of equipment and buildings over their useful lives.
Is share-based pay a non-cash item?
Yes, but it is a real cost to owners because it reduces their percentage of the business.
Where do I find non-cash items?
In the reconciliation at the top of the cash flow statement under the indirect method. Each adjustment is listed as a separate line, which makes it easy to see how profit becomes cash.
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