Final answer:
We add depreciation back to net income to accurately reflect the cash flow generated by a business, as depreciation is a non-cash accounting expense that doesn't represent an immediate cash outflow. This adjustment helps in better assessing business performance and planning for investments.
Step-by-step explanation:
We add depreciation back to net income because depreciation is a non-cash expense that reduces net income on the income statement but does not actually represent a cash outflow for the business during the period. When calculating cash flows from operations, the aim is to assess the cash the business generated, hence earnings before interest, taxes, depreciation, and amortization (EBITDA) is often a focus. Since depreciation is merely an accounting estimate of the decline in value of an asset over time, adding it back ensures that we accurately measure the real cash flow available to the business.
For example, according to the national accounts, the net national product (NNP) is calculated as the gross national product (GNP) minus depreciation. This includes all income generated by businesses and individuals, highlighting the importance of understanding depreciation from both accounting and economic perspectives.
Furthermore, when firms invest in new equipment or facilities, they do not pay for depreciation upfront but over the life of the asset. Therefore, for investment and planning purposes, managers must consider cash flows without the immediate impact of depreciation, which illustrates the usefulness of adding it back to net income.