What depreciation is
When a company buys a long-lived asset, such as a truck, a building or a server, it doesn't expense the full cost right away. Instead it spreads the cost over the asset's useful life. That yearly expense is depreciation. It's a non-cash expense: the cash left when the asset was bought (as capex); depreciation just allocates that cost over time.
The $10 example (25% tax rate)
1. Income statement
Depreciation is an operating expense, so EBIT falls by $10. Lower pre-tax income means taxes fall by $10 × 25% = $2.50. Net income falls by $10 − $2.50 = $7.50.
2. Cash flow statement
Cash flow from operations starts with net income: −$7.50. Depreciation is non-cash, so we add it back: +$10. Net change in cash: +$2.50. The company is better off by exactly the tax it no longer pays.
3. Balance sheet
- Assets: cash +$2.50; PP&E (net) −$10. Total assets −$7.50.
- Liabilities and equity: retained earnings falls with net income, −$7.50.
Both sides fall by $7.50, so the balance sheet balances.
| Statement | Line | Change |
|---|---|---|
| Income statement | Depreciation | +10.00 expense |
| Taxes | −2.50 | |
| Net income | −7.50 | |
| Cash flow | Net income | −7.50 |
| Add back depreciation | +10.00 | |
| Change in cash | +2.50 | |
| Balance sheet | Cash | +2.50 |
| PP&E (net) | −10.00 | |
| Retained earnings | −7.50 |
Shortcut to remember: a non-cash expense lowers net income by (1 − tax rate) × the expense, and raises cash by tax rate × the expense. That extra cash is the depreciation tax shield.
Where capex fits
Depreciation and capex are two sides of the same asset. Capex is the cash spent to buy PP&E (in cash flow from investing), and it increases PP&E on the balance sheet. Depreciation reduces PP&E over time. The PP&E roll-forward ties them together:
Ending PP&E = beginning PP&E + capex − depreciation
That's exactly what our free IronLeaf Fitness PP&E template builds, including a depreciation waterfall by year of purchase.
Common follow-ups
- Why doesn't depreciation reduce cash? The cash went out when the asset was bought; depreciation only spreads the accounting cost.
- What if depreciation isn't tax-deductible? Then taxes don't change: net income falls $10, cash is unchanged, and PP&E and retained earnings each fall $10. (Book and tax depreciation can differ in practice, creating deferred taxes, but interviews usually assume they match.)
- How is amortization different? Same mechanics, but for intangible assets like capitalized software or acquired customer relationships.
See it move in a live model
Our free Trailhead Outfitters template links all three statements with a balance check.