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 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 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 for 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.
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