Why Your P&L Isn’t Telling You About Cash? DEBUNKING A COMMON MYTH!

Part 1- Why are Depreciation and Amortization included into the P&L?

I've been seeing a lot of posts lately about the Profit & Loss (or Income) Statement and EBITDA, so I thought I'd throw in my two cents... 🪙🪙

The most common misconception I see is that people believe the P&L reflects cash flow… while it does not! NOT AT ALL!

It’s crucial to understand this: the P&L’s purpose is NOT to show how much cash profit the business has generated - that’s the Cash Flow Statement’s job. Instead, P&L FOCUSES ON TRACKING THE "COSTS“ (expenses) INCURRED TO GENERATE INCOME over a specific period to DETERMINE THE PROFITABILITY... NOT THE PROFIT!

THIS DISTINCTION EXPLAINS WHY P&L's NET INCOME NEVER ALIGN WITH THE END OF THE PERIOD CASH POSITION! 

The main reason is that non-cash expenses (like Depreciation and Amortization) are included in the P&L, while real cash outflows (like Loan Principal repayments) are not. Though it might seem counterintuitive, it’s actually 100% logical… and here’s why…

Let’s start with the first common question people struggle with: 

“Why are Depreciation and Amortization included into the P&L, while those are clearly accounting conventions?“

Well, let’s start to remind everyone what Depreciation and Amortization are all about: matching the cost of an expensive equipment (most of the time) with the time span it will be used to help the company make money. 

In essence if a car cost $50k and is expected to be used for a five years period, it is fair to consider the contribution of this car to the generation of the sale to be $50k / 5 years, i.e. $10k per year, right?

The same concept applies to intangible assets, like software. For instance, when perpetual licenses were available, a single-user AutoCAD license cost around $5,000. Though it was a one-time expense, the software supported multiple projects over several years before needing an upgrade. 

This aligns with the accounting principle of matching costs with revenues.

For physical assets (like a car), this allocation over time is known as Depreciation. For intangible assets (like software or licenses), it’s called Amortization. IGNORING THESE COSTS WOULD OVERLOOK THE GENUINE CONTRIBUTION THESE ASSETS MAKE TO THE BUSINESS during the given period. 

So, to accurately capture ALL the expenses involved in generating income over a given period, it’s logical to include the contributions made by both tangible and intangible assets, reflected in Depreciation and Amortization. 

Making sense now?

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