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Some people add back depreciation to net income, and then deduct capital expenditure from the net income, to reach what they consider the "true cash flow" or earning power of the company.

What is the reason for that?

Is it because capital expenditure is like, "have to spend the cash, but cannot deduct it from revenue except for its current year's depreciation" (and it doesn't affect the net income except for the current year's depreciation portion), so the net income is "inflated" and therefore we have to deduct it from the net income?

And depreciation is like, "don't have to spend the cash for this depreciation amount", but can be subtracted from the net income (as cost), so the net income is "deflated" and therefore, we need to add the depreciation back to the net income?

Essentially, then, it is to completely negate the usage and effect of "depreciation" -- as if companies don't depreciate but take the whole cost each year "as is"?

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Net Income includes both cash and non-cash expenses, so to get "true" operating cash flow you'd add back depreciation since it's a non-cash expense. It's generally easier to take the "net" totals and add back any non-cash items that to break down net items into cash and non-cash items.

Take this simple example. Say you own a widget machine that produces one widget. that widget cost you $10 and you sold it for $25. You depreciate the cost of the machine at a rate of $5 per year.

Your net income is therefore:

             Revenue $25 
- Cost of Goods Sold $10
-       Depreciation $ 5
------------------------
          Net Income $10

But the amount of cash that you earned is $15, which you can also get by adding depreciation (which doesn't affect cash) back to your net income.

Capital Expenditures are not included in net income either (they affect the balance sheet, not the income statement), so to get the total cash flow, you'd deduct those from net income to get total operating and investing cash flow.

In reality you'd also include financing activities like loans made or paid back, and any equity (stock) you issued or bought back to get the full total cash flow.

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  • I was thinking: if a company buys $100,000 of computer for the past 50 years, and so the capital expenditure is $100,000 of computer and depreciating past 5 years of $20,000 each year, then they balance out. Net Income + $100,000 - $100,000 = original net income, so it was accurate earning power. But what if the capital expenditure is to buy warehouses? Let's say the company also did it for past 50 years, then they also balance out, but now, the company is worth a lot more because all the "capital expenditure" did not go to $0 like computers but is increased 5 times, or 10 times, or 20 times – nonopolarity Sep 10 '19 at 14:02
  • @太極者無極而生 I don't follow your question, but warehouses don't depreciate to zero, they will depreciate to some "salvage" value (the real estate value may go up but there will be costs to bring the warehouse back to "new" status). – D Stanley Sep 10 '19 at 18:34
  • I was saying for earning power, capital expenditure to buy computers vs to buy warehouse, are very different. One really depreciate to very low value. But the other appreciate to a few times worth. – nonopolarity Sep 11 '19 at 4:15

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