Frequently Asked Questions

Why is depreciation added back in the calculation of a company's earnings?

Depreciation is a key component in the calculation of a company's earnings, specifically within the EBITDA (Expenses Before Interest, Taxes, Depreciation, and Amortization) framework. Depreciation refers to the gradual reduction in the value of an asset over its useful lifetime. This reduction in value is deducted annually from the company's taxable income, effectively reducing the amount of taxes the business has to pay each year. However, it's important to note that depreciation is a non-cash expense. This means that while it impacts the company's financial statements, it doesn't involve an actual outflow of cash from the business. Therefore, when calculating a company's true earnings, depreciation is added back. This adjustment provides a more accurate reflection of the company's cash flow and the income a new owner can expect in the future. Moreover, when a business is sold, the new owner may not have the same depreciation expenses, especially if the previous owner had already accounted for the depreciation of major assets. Therefore, adding back depreciation can provide a clearer picture of the company's operational profitability, excluding the effects of accounting conventions like depreciation.