Depreciation and Amortization

Non-cash expenses that systematically allocate the cost of tangible and intangible assets over their useful lives.

Depreciation and Amortization (D&A) are non-cash accounting methods used to spread the cost of an asset over its estimated useful life. Depreciation applies to physical, tangible assets such as machinery, buildings, vehicles, and servers. Amortization applies to non-physical, intangible assets such as patents, trademarks, proprietary software, and customer lists. Rather than expensing the entire cost of a major purchase in year one, companies use D&A to match the expense of the asset with the revenue it helps generate over time. On the financial statements, D&A is recorded as an expense on the income statement, which reduces reported operating income and net income. However, because no actual cash leaves the company when D&A is recorded, these expenses are added back to net income on the statement of cash flows to determine the true operating cash flow generated by the business during the period. Investors analyze D&A to understand a company's capital intensity and the age of its assets. While adding back D&A makes earnings look stronger under metrics like EBITDA, investors must be cautious. A high D&A expense indicates that the company has made heavy capital expenditures in the past, and it will likely need to spend significant cash in the future to replace those wearing-out physical assets or expiring intangible licenses. Ignoring D&A entirely can lead to overestimating a company's long-term free cash flow.

Company A buys a manufacturing machine for $500,000 with an expected useful life of 10 years and a salvage value of $50,000. Under straight-line depreciation, the depreciable base is $450,000 ($500,000 cost - $50,000 salvage value). The annual depreciation expense is $450,000 / 10 years = $45,000 per year.