What are Non-Cash Expenses?
Non-cash expenses appear on an income statement because accounting principles require them to be recorded despite not actually being paid for with cash. The most common example of a non-cash expense is depreciation, where the cost of an asset is spread out over time even though the cash expense occurred all at once.
How Non-Cash Expenses Work
Here is an example of how a non-cash expense occurs:
- On July 1, 2017, a company purchases a computer for $2,500 with cash. The computer is estimated to have a useful life of five years, so an annual depreciation expense of $500 is created for the next five years.
- In 2017, the company will have a depreciation expense of $500 on the income statement, and an investment of $2,500 on the cash flow statement.
- In 2018, the company will have a depreciation expense of $500 on the income statement, and no investment recorded on the cash flow statement.
- This continues until 2022 when the depreciation from this computer is now $0 because it is fully depreciated.
As you can see, the $500 depreciation expense is actually a non-cash item, and the capital cost is recorded only once on the cash flow statement.
List of the Most Common Non-Cash Expenses
There are many types to watch out for, but the most common examples include:
- Stock-based compensation
- Unrealized gains
- Unrealized losses
- Deferred income taxes
- Goodwill impairments
- Asset write-downs
- Provisions and contingencies for future losses
Why Non-Cash Charges Need to be Adjusted for in Financial Analysis
When performing a financial valuation of a company, an analyst typically performs a Discounted Cash Flow (DCF) analysis based on its Free Cash Flow (FCF). FCF is used because it demonstrates the true economic viability of a company.
Since analysts can’t use net income in a DCF model, they need to adjust net income for all the non-cash charges (and make other adjustments) to arrive at free cash flow.
Below is an example of how an analyst would make the above adjustments when building a financial model.
Source: CFI financial modeling courses.
Thank you for reading this guide to non-cash expenses and charges that need to be adjusted in financial modeling and valuation. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: