The Short Version
Depreciation spreads the cost of a physical asset (like machinery or a building) over its useful life instead of expensing the entire cost the moment it's purchased. Amortization does the same thing for intangible assets, like patents or acquired trademarks. Both are non-cash expenses — they reduce reported profit without any cash actually leaving the company in that period, which is exactly why they get added back when calculating EBITDA and free cash flow.
Explain It Like I'm 10
Imagine you buy a $100 bike that you expect to use for 5 years. Instead of saying you 'spent $100' all in one single day, it makes more sense to think of it as costing about $20 of value 'used up' each year for 5 years. That yearly $20 'using-up' cost is depreciation. Amortization is the exact same idea, just for things you can't touch, like a patent or a trademark you bought.
Step-by-Step Example
- 1 Company buys a machine for $1,000,000, expected to last 10 years.
- 2 Instead of recording a $1,000,000 expense the day it's purchased, it spreads the cost out.
- 3 Each year, it records Depreciation Expense = $1,000,000 ÷ 10 = $100,000.
- 4 This $100,000 reduces reported profit each year, but no actual cash leaves the company in that specific year — the cash was already spent back on day one.
- 5 This is exactly why depreciation gets ADDED BACK when calculating EBITDA and Free Cash Flow — those measures care about real cash, and depreciation isn't a current cash cost.
A company buys a $1 million machine expected to last 10 years. Instead of recording a $1 million expense immediately, it might record $100,000 of depreciation expense each year.
Quick Recap
- ✓ Non-cash expense: reduces net income on paper but doesn't consume cash in the period it's recorded.
- ✓ The actual cash was already spent (or will be) when the asset was purchased — tracked in investing activities on the cash flow statement.