Final answer:
Depreciation is added back to net income when calculating free cash flow because it is a non-cash expense that needs to be accounted for to gauge the actual cash available for reinvesting, debt payment, or returning value to shareholders. It enables a better understanding of a company's growth potential through reinvestment.
Step-by-step explanation:
Handling Depreciation in Free Cash Flow
When calculating free cash flow (FCF), depreciation is handled in a unique way because it is a non-cash expense. Companies record depreciation to account for the wear and tear of tangible assets over time. However, because it does not result in an outflow of cash, we add back depreciation to the net income when calculating FCF. Doing so provides a more accurate representation of the actual cash available to the business for reinvestment, paying debts, or returning value to shareholders.
Understanding the role of depreciation in FCF is crucial because it affects the assessment of a company's profitability and sustainability. For example, a business can grow by reinvesting its FCF into new factories, technology, or staff. This reinvestment can lead to an increase in production, additional sales, and consequently, a larger cash flow in future periods. If the cash reinvested outpaces the natural depreciation of assets, the company can maintain or even accelerate its growth trajectory.
Therefore, depreciation is added back to the net income within the FCF calculation because it provides insight into the potential for growth through reinvestment, particularly if the company remains profitable and the reinvested cash flow is larger than the degradation of its assets.