Depreciation and Amortisation Explained

Depreciation and amortisation spread the cost of a long-lived asset across the years it is used, instead of charging it all at once. Depreciation applies to physical assets, amortisation to intangibles. Both are non-cash expenses: they reduce reported profit without any cash leaving the business, which is why free cash flow adds them back.

Depreciation is where accounting and cash flow part company, and understanding the gap is one of the most useful skills an investor can build. It is the reason a profitable company can be flush with cash, and the reason a company reporting strong earnings can quietly be running its assets into the ground.

Where this fits: depreciation and amortisation link the income statement to the cash flow statement and are the mirror image of capital expenditure. They matter for judging free cash flow and business quality under the Five Criteria.

The Matching Principle

The whole idea rests on one accounting rule: the matching principle. Costs should be recognised in the same period as the revenue they help generate.

When a company buys a machine that will produce goods for ten years, it would be misleading to charge the entire cost against profit in year one and nothing thereafter. Year one would look terrible and the next nine would look artificially good. So the cost is spread across the ten years the machine is useful. That spreading is depreciation.

The same logic applies to intangible assets with a finite life, such as a patent or an acquired customer list. Spreading their cost is called amortisation. The mechanics are identical; only the type of asset differs.

	Depreciation	Amortisation
Applies to	Tangible assets	Intangible assets
Examples	Machinery, vehicles, buildings	Patents, licences, acquired software
Where it starts	Capital expenditure	Intangible purchase or acquisition
Income statement effect	Reduces operating profit	Reduces operating profit
Cash effect	None (non-cash)	None (non-cash)

Note that land is not depreciated, because it does not wear out, and goodwill is not amortised at all, as covered in our goodwill guide.

Why It Is Non-Cash

This is the single most important point. The cash left the business when the asset was bought; that outflow was recorded as capital expenditure in the investing section of the cash flow statement. Depreciation in later years is just a bookkeeping entry that recognises the asset being used up. No money changes hands.

That is why, on the cash flow statement, depreciation and amortisation are the very first thing added back when moving from profit to operating cash flow. You start with net profit, which has been reduced by these charges, and add them back because they did not actually consume cash.

The result is that operating cash flow is almost always higher than reported profit, and the difference is largely depreciation and amortisation. A company with heavy depreciation can look only modestly profitable yet generate strong cash. This is a feature of how the two statements fit together, not an anomaly.

The Methods, Briefly

You do not need to be an accountant, but it helps to know the main approaches, because they change the shape of the charge over time.

• Straight-line spreads the cost evenly. An asset costing £10m with a ten-year life and no residual value is depreciated at £1m a year. This is the most common method and the easiest to interpret.
• Reducing balance (accelerated) charges more in the early years and less later. It better reflects assets that lose value fastest when new, such as vehicles or technology.
• Units of production ties the charge to usage, so a machine depreciates faster when it runs harder. It is common in mining and heavy industry.

The method matters because it affects when profit is reduced. Two identical companies using different methods will report different profits in any given year, even though their cash flows are identical.

The Estimates That Flatter Profit

Here is where investors need to be alert. Depreciation depends on two management estimates:

1. Useful life: how many years the asset is expected to last.
2. Salvage (residual) value: what it will be worth at the end.

Both are judgements, and both can be stretched. If a company lengthens the assumed useful life of its assets, the annual depreciation charge falls and reported profit rises, with no change whatsoever in the underlying business. It is a perfectly legal way to make earnings look better.

Imagine a company, Company E, that owns equipment it has always depreciated over eight years. (This example is hypothetical.) One year, management decides the equipment really lasts twelve years and extends the useful life. The annual depreciation charge drops by a third, and operating profit jumps, purely from an accounting assumption. A careful investor reading the notes would spot the change and discount the profit improvement accordingly.

This is exactly the kind of thing that separates reported earnings from real earnings quality. Changes to depreciation assumptions, especially ones that conveniently lift profit in a weak year, belong on any list of red flags. The accounting notes disclose these changes; it is worth the few minutes to read them.

The EBITDA Trap

Because depreciation and amortisation are non-cash, it has become fashionable to strip them out and quote EBITDA: earnings before interest, tax, depreciation and amortisation. EBITDA has a legitimate use. It lets you compare the operating profitability of companies with different debt levels, tax situations and depreciation policies on a like-for-like basis.

But treating EBITDA as a proxy for cash flow is one of the most dangerous habits in investing. EBITDA says, in effect, “ignore the cost of the assets we use.” Yet those assets wear out and must be replaced, and replacing them costs real cash. For a capital-heavy business, that cash is enormous.

Charlie Munger put it with characteristic bluntness, suggesting that every time you see the word EBITDA you should mentally substitute “bullshit earnings,” precisely because it pretends depreciation is not a real cost. Warren Buffett has made the same point more gently: depreciation is the worst kind of expense to ignore, because it reflects cash already spent on assets that will have to be bought again.

The honest test is to compare EBITDA with free cash flow. If a company’s EBITDA is far larger than its free cash flow year after year, the gap is being eaten by capital spending, and EBITDA is flattering the picture. For an asset-light business the two are close; for a heavy industrial they can be worlds apart.

Depreciation vs CapEx: The Reinvestment Check

One of the most revealing checks you can run is to compare a company’s depreciation with its actual capital expenditure over several years.

Relationship	What it usually means
CapEx roughly equal to depreciation	Steady state; the business is replacing assets as they wear out
CapEx consistently above depreciation	Growth phase; the business is expanding capacity
CapEx persistently below depreciation	Possible underinvestment; assets may be ageing faster than they are replaced

That last row is the warning. A company spending less on new assets than its depreciation charge may be quietly running down its asset base to prop up short-term cash flow. It looks healthy now, but the reinvestment it is skipping will come due later, often all at once. This trick can make free cash flow look artificially strong for a few years, which is why you always check the trend rather than a single year.

How I Use Depreciation in Analysis

When I study a company, depreciation gets a dedicated pass:

1. Add depreciation and amortisation back to understand the cash versus profit gap, then see how much of the difference between profit and operating cash flow it explains.
2. Compare depreciation with CapEx over five to ten years, using the table above, to judge whether the business is reinvesting enough.
3. Read the accounting notes for useful-life assumptions and any changes to them. A quiet extension of asset lives is a flag.
4. Compare EBITDA with free cash flow. A persistent, large gap means EBITDA is overstating the owner’s cash.
5. Separate operating depreciation from acquisition-related amortisation. Amortisation of acquired intangibles says more about past deals than about current operating costs, and many investors add it back when judging underlying earning power, while staying alert to the capital that was spent to create it.

Having worked on the company side, I know how closely analysts watch depreciation policy, because it is one of the few large expenses management can influence through assumption rather than action. That makes it both a useful signal and a place to be sceptical.

Frequently Asked Questions

Is depreciation a cash expense? No. Depreciation is a non-cash accounting charge. The cash was spent when the asset was bought, recorded as capital expenditure. Depreciation simply spreads that past cost across the years the asset is used, which is why it is added back when calculating cash flow.

What is the difference between depreciation and amortisation? They do the same job for different assets. Depreciation spreads the cost of tangible assets such as machinery, vehicles and buildings. Amortisation spreads the cost of intangible assets such as patents, licences and acquired software. The principle is identical; only the type of asset differs.

Why do companies add back depreciation in cash flow? Because it reduced reported profit without using any cash. To move from profit to cash generated, you reverse non-cash charges like depreciation and amortisation. This is the first adjustment in the operating section of the cash flow statement.

Is EBITDA the same as cash flow? No, and treating it as such is a common and costly mistake. EBITDA adds back depreciation and amortisation but ignores the real cash a business must spend to replace its assets. For capital-heavy businesses, EBITDA can overstate the cash available to owners by a wide margin.

Can changing depreciation assumptions boost profit? Yes. Lengthening the assumed useful life of assets lowers the annual depreciation charge and raises reported profit with no change to the business itself. The accounting notes disclose such changes, so reading them is worthwhile when earnings improve without an obvious operating reason.

Your Next Step

Pull depreciation and CapEx side by side for one company you follow over the past decade, and check which of the three patterns in the table above it fits. Then read CapEx vs OpEx to see the spending that creates the charge, and free cash flow to understand why adding depreciation back is only half the story. For the intangible side, our goodwill and intangible assets guide explains what gets amortised and what does not.

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About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.

The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.