“The only cash that company generated was from depreciation and amortization”

Occasionally you will hear a security analyst make this kind of a statement about a company that has a less than desirable operating cash flow when they are discussing its’ financial performance. The basis of this statement is the “non-cash charge” concept which can be rather puzzling to those who may not have had a hands-on exposure to accounting in a business environment. So, I think it’s necessary to gain a better understanding of this accounting concept and, more importantly, how it is connected to other accounting subjects in the BOK that you might find in the form of CTP exam questions.

Briefly, a non-cash charge is an expense line item on the Income Statement for which “no check has been written” (i.e. no money has left the company bank account). Depreciation and Amortization are the most typical non-cash charges that are found on the Income Statement and they reflect an IRS tax ruling that recognizes that a company’s long-term assets lose their ability to produce profit over time. So, this ruling allows a company to include a portion of a long-term assets’ value as an expense on the Income Statement for every year over the useful life of the asset. Clearly, this accounting procedure, where tangible assets (e.g. plant and equipment) are Depreciated and intangible assets (e.g. patents and copyrights) are Amortized, helps to reduce a companies’ tax burden.

The following four BOK subject matter areas embody the “non-cash charge” concept:

1) The Statement of Cash Flows

In the first “Activities” section, Cash Flows from Operations, the non-cash charges of Depreciation and Amortization are added to Net Income for the purpose of re-stating Net Income on a cash flow basis. (Recall that the D&A expense line items do not cause an outflow of cash)

Tip: even though the BOK Exhibits do not show an adjustment to Net Income for Amortization expense, I think that it’s possible that an exam question could require you to include it in your answer.

2) EBITDA

This very popular financial measure answers the question; “how much would Operating Income be if the non-cash charges of Depreciation and Amortization were not subtracted from Revenue on the Income Statement”. In other words, since EBIT and Operating Income are (for the purposes of the BOK) the same, EBITDA simply re-states Operating Income on a cash flow basis.

3) EBITDA Margin

This margin calculation is equal to;  EBITDA / Revenue, and for the reasoning discussed in (2) above, is a cash flow measure that indicates the amount of cash flow generated per dollar of revenue.

4) Cash Flow to Total Debt Ratio

In this Debt Ratio, the numerator is equal to; Net Income + Depreciation, and possibly, plus Depreciation (see Tip in (1) above). Therefore, in the numerator, Net Income is re-stated on a cash flow basis just like in the Cash Flow from Operations section of The Statement of Cash Flows. And answers the question; “how well does the company cover its Total Debt with cash flow”.  

Finally, the IRS also allows natural resource extraction industries (e.g. petroleum and mining) to include an expense line on the Income Statement for Depletion Allowance which is also a non-cash charge. So, if you should get an exam question that addresses any of the four subject matter areas mentioned above, remember to include Depletion in arriving at your answer if it is mentioned as part of the input data to the question.      

-George Schilling, CTP