How does depreciation affect EBIT and cash flow in financial statements?

• A. Depreciation lowers EBIT and increases cash flow.
• B. Depreciation lowers EBIT but is a non-cash charge; cash flow is affected through tax shield and non-cash adjustments.
• C. Depreciation raises EBIT.
• D. Depreciation has no effect on cash flow.

Answer: (B)

Depreciation lowers EBIT because it is an operating expense that reduces earnings before interest and taxes. But it’s a non-cash charge, so it doesn’t involve an actual cash outflow today. The cash flow impact comes from two sources: the tax shield and the non-cash adjustment in the cash flow statement. The tax shield arises because depreciation lowers taxable income, reducing taxes paid and boosting cash flow. In the cash flow statement (indirect method), depreciation is added back to net income since it reduced reported earnings but didn’t reduce cash. So, depreciation digs EBIT down, but it can increase cash flow through tax savings and by being added back as a non-cash adjustment.