Depreciation and capex

10 min read

Read firstHow the statements connect. Valuation without accounting is memorization.

Ask what does to cash and most people say the same thing: it is a , so add it back and you have cash flow. The add-back is correct. The conclusion is wrong in a specific and useful way, and a retailer is the clearest place to see why.

The number that shows the problem

Target Corporation, the gap between EBITDA and free cash flow$ millions, fiscal 2025

	FY2025
Operating income	5,117
Plus depreciation and amortization	3,134
EBITDA	8,251
Cash from operations	6,562
Less capital expenditures	negative 3,727
Free cash flow	2,835

Target Corporation, Form 10-K for Fiscal 2025. Free cash flow is operating cash flow less capital expenditures, which is a convention rather than a reported line.

of $8,251M. of $2,835M. The add-back removed $3,134M of accounting charge, and then $3,727M of actual cash walked out the door to build and refit stores. Depreciation is not a fake expense. It is a real expense recorded in the wrong year, and are where the cash actually goes.

Following one asset all the way through

Worked example

A $100 store fitting, ten-year life, funded by debt at 5%

Day one. Cash out $100 in investing, cash in $100 in financing. Property and equipment up $100, debt up $100. The income statement is untouched, because buying a long-lived asset is not an expense.

Year one. Straight-line depreciation of $10 and interest of $5 cut pretax income by $15. At a 25% tax rate net income falls $11.25. Add back the $10 of depreciation and operating cash flow falls $1.25, which is the after-tax interest. Property falls to $90.

Years two through ten. The same $10 charge each year, so by year ten the asset is fully depreciated and carried at zero. It may still be working perfectly. Book value only ever tracked the schedule someone wrote down on day one.

Year eleven. If the fitting still works, depreciation stops and reported profit jumps by $10 with no operational change at all. If it needs replacing, another $100 leaves. Neither of those is visible in EBITDA.

TransactionAmount ($)Tax rate (%)

Depreciation goes up by $10.00. Nothing else changes.

Income statement

Depreciation: -$10.00
Pretax income: -$10.00
Taxes: +$2.50
Net income: -$7.50

Cash flow statement

Net income: -$7.50
Depreciation add-back: +$10.00
Cash from operations: +$2.50
Net change in cash: +$2.50

Balance sheet

Cash: +$2.50
PP&E: -$10.00
Total assets: -$7.50
Retained earnings: -$7.50
Liabilities and equity: -$7.50

Balanced. Assets moved -$7.50, liabilities and equity moved -$7.50.

Switch the transaction above to "Buy equipment with new debt" and then to "That equipment, one year later" to see both halves.

Maintenance capex, the number nobody discloses

Some capital spending keeps the business where it is and some grows it. The split is what you actually want and no company reports it, so everyone estimates.

The common shortcut is to treat depreciation as , on the reasoning that depreciation measures the assets being consumed. It works for a stable business with a mature asset base and it fails in two directions. For a fast-growing company, depreciation reflects a smaller asset base from years ago and understates what maintenance costs now. For a company that has been under-investing, depreciation reflects assets bought when they were cheaper, and makes the replacement more expensive than the charge.

Target Corporation spent $3,727M against $3,134M of depreciation, so roughly $593M more than the charge. The describes what the spending was for, and two paragraphs of that description tell you more than the gap between the two numbers ever will.

Straight line, and the alternatives

Straight-line spreads cost evenly: a $100 asset with a ten-year life and no salvage value depreciates $10 a year. Accelerated methods front-load the charge, which matches assets that lose most of their value early.

Almost every US company reports straight-line to shareholders and uses accelerated methods on its tax return, because a faster deduction is worth more today. That divergence is not an accounting trick, it is two sets of rules with different purposes, and it creates . Book depreciation and tax depreciation are different numbers on purpose.

Test yourself

01A company's capex has been half its depreciation for four years. What does that tell you?

The asset base is shrinking. Either the company found genuine efficiency, or it is under-investing and the bill arrives later as a step change in spending or as lost competitiveness. Check whether revenue per store, per square foot, or per unit of capacity is holding. Under-investment flatters free cash flow for exactly as long as it takes for the assets to matter.

02Why does an acquisitive company often have higher D&A than a comparable one that built the same assets?

Purchase accounting. An acquisition marks the acquired assets to fair value and identifies intangibles that get amortized, while a company that built the same capability internally expensed most of it as it went. Two identical businesses, different D&A, different EPS, same cash. It is one reason EV/EBITDA gets preferred to P/E for comparing across acquirers and builders.

03If depreciation increases by $10 and the tax rate is zero, what happens to cash?

Nothing. Net income falls $10, the full $10 is added back, and operating cash flow is unchanged. The entire cash effect of depreciation in the standard question is the tax shield, so setting the tax rate to zero removes it. Being able to say that is how you show you understand the mechanism rather than the recipe.

A tutor that knows this lesson. It asks before it explains, and it will not tell you what to do with your own money.

Every figure in this lesson that names a company comes from Target Corporation's Form 10-K for Fiscal 2025, the year ended 2026-01-31, filed 2026-03-11. Educational material, not investment advice.