74 ACCOUNTING FOR MANAGERS
It is important to recognize that the cash outflow of £100,000 occurs when the asset
is bought. The depreciation charge of £20,000 per annum is a non-cash expense
each year. However, the value of the asset in the Balance Sheet reduces each year
as a result of the depreciation charge, as follows:
Original Provision for Net value in
asset cost depreciation Balance Sheet
End of year 1 100,000 20,000 80,000
End of year 2 100,000 40,000 60,000
End of year 3 100,000 60,000 40,000
End of year 4 100,000 80,000 20,000If the asset is then sold, any profit or loss on sale is treated as a separate item in the
Profit and Loss account. Alternatively, the asset can be depreciated to a nil value
in the Balance Sheet even though it is still in use.
A type of depreciation used for certain assets, such as goodwill or leasehold
property improvements, is calledamortization, which has the same meaning and
is calculated in the same way as depreciation.
In reporting profits, some companies show the profit before depreciation (or
amortization) is deducted, because it can be a substantial cost, but one that does
not result in any cash flow. A variation of EBIT (see earlier in this chapter) is
EBITDA: earnings before interest, taxes, depreciation and amortization.
Reporting cash flow.....................................
The third financial statement is the cash flow. TheCash Flow statementshows the
movement in cash for the business during a financial period. It includes:
žcash flow from operations;
žinterest receipts and payments;
žincome taxes paid;
žcapital expenditure (i.e. the purchase of new fixed assets);
ždividends paid to shareholders;
žnew borrowings or repayment of borrowings.
The cash flow from operations differs from the operating profit because of:
ždepreciation, which as a non-cash expense is added back to profit (since
operating profit is the resultafterdepreciation is deducted);
žincreases (or decreases) in working capital (e.g. debtors, inventory, prepay-
ments, creditors and accruals), which reduce (or increase) available cash.