Non-Cash Expense refers to those expenses which are reported in the income statement of the company for the period under consideration but does not have any relation with the cash i.e., they are not paid in the cash by the company and includes expenses like depreciation, etc.
What is a Noncash expense?
Non cash expenses are expenses that are not related to cash. Even if they’re reported in the income statement, they have nothing to do with the payment of cash.
The most common non cash expense is depreciation. If you have gone through the financial statement of a company, you would see that the depreciation is reported, but actually, there’s no payment of cash.
For example, we can say that Tiny House Builders Inc. buys new equipment. They see that they need to charge $10,000 for depreciation. If they need to report the depreciation for the next 10 years, they will report the depreciation for the equipmentDepreciation For The EquipmentDepreciation on Equipment refers to the decremented value of an equipment's cost after deducting salvage value over the life of an equipment. It lowers its resale value.read more for the next 10 years. But actually, there would be no cash payment.
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Why do non cash expenses need to be recorded?
As per the accrual accountingAccrual AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. read more, the items need to be recorded whenever the transaction happens.
For example, when the sales are being initiated, the sales should be recorded in the income statement irrespective of the money received or not. On the other hand, in cash accountingCash AccountingCash Accounting is an accounting methodology that registers revenues when they are received & expenditures when they are paid in the given period, thereby aiming at cash inflows & outflows. read more, only when the cash is being received, the sales would be recorded.
And for the same reason, we need to record non cash expenses even when the company doesn’t pay out anything in cash.
List of Non Cash Expense Examples
Let’s look at the most used non cash expense examples below and understand how they work.
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For eg:
Source: Non Cash Expense (wallstreetmojo.com)
#1 – Depreciation:
As mentioned earlier, depreciation is a non cash expense. If a company buys any machinery or asset, it needs to set aside a certain amount of wear and tear. And that expense is recorded every year in the income statement of the company. This expense is called depreciation, and it is a non cash expense.
source: Ford SEC Filings
#2 – Amortization:
Amortization Expense is just like depreciation, but for the intangible, Let’s say that a company has built a patent by expending around $100,000. Now, if it lasts for 10 years, then the company has to record the amortization expense of $10,000 each year as an amortization expense.
source: Amazon SEC Filings
#3 – Unrealized gains & unrealized losses:
These are two sides of the same coin. When an investor invests in investment and feels that the investment would earn them more profits in the future, we call it unrealized gainsUnrealized GainsUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal.read more. Actually, there’s no cash profit. It’s just on the paper until the position is closed. On the other hand, the unrealized loss is also the same. But in this case, the investor feels that the investment will yield more future losses (but only on paper). Since these are not cash profits or losses, we will only consider them as non cash items (the unrealized loss can be termed as a non cash expense).
source: Amazon SEC Filings
#4 – Stock-based compensation:
Many companies pay their employees stock optionsEmployees Stock OptionsEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). read more. These stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium.read more are included in the compensation package. These are not direct cash, but they’re the company shares. When a company doesn’t have enough cash to pay off its employees, they go for stock-based compensationStock-based CompensationStock-based compensation also called share-based compensation refers to the rewards given by the company to its employees by way of giving them the equity ownership rights in the company with the motive of aligning the interest of the management, shareholders and the employees of the company.read more. Even the employees leave the organization; they can get full value out of their stock-based
#5 – Provisions for future losses:
Companies often create provisions for expected losses. For example, if a company sells a portion of their total sales on creditSales On CreditCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more, then there’s always a chance that they wouldn’t receive the whole amount in cash. Few customers may not pay at all, and the company would need to call them “bad debt.” Before the effect of “bad debt” hits the company, the company wants to protect its own interest. And that’s why they create “provisions for bad debt.” And this is one of the non cash expenses because nothing goes out in cash.
Why are non cash expenses adjusted for valuing a company?
When financial analysts look at the free cash flow of the company while conducting a discounted cash flow valuation method, noncash-expensesNoncash-expensesNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation.read more have no place in it. These noncash expenses reduce the actual cash if they’re not adjusted.
That’s why these expenses are added back while calculating the free cash flow of the firm. Since the free cash flow of the firm states the financial viability of the business, we can’t include non cash expenses.
Conclusion
Non-cash expenses are useful when we record them in the income statement. Recording non-cash expenses allow us to find out the net income.
But the net income of a company isn’t always useful for investors. They want to know what the company’s actual worth is. That’s why we need to value a business. To value a business, we need to examine the cash flow of businessCash Flow Of BusinessCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more. And while calculating the free cash flowCash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).read more, we will add back the non-cash expenses so that we can get the actual cash inflow/outflow.
Non Cash Expense Video
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