Non-cash expenses explained and some common examples

In recent years, as opportunities for revenue growth across various industries become limited, companies have focused on reducing expenses. In finance, you learn various ways to analyze expenses such as operating expenses, selling expenses, and cost of goods sold. Company leaders and founders often review GAAP and operating expenses, and while non-cash expenses might seem less crucial due to the absence of outgoing cash, it is essential to evaluate the company's expenses from both cash and non-cash perspectives. 
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This article addresses the critical aspects of expense analysis with a specific focus on non-cash expenses. Understanding these expenses is paramount for business leaders, founders, and financial professionals who aim to steer their organizations toward sustainable growth and operational efficiency.

What are cash expenses? 

For a typical business, employee salary(payroll), rent, interest expenses, supplies, marketing, employee benefits, insurance, and taxes are all standard cash expenses.

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Cash expenses are often in exchange for services or goods that are essential to operate the business. These expenses result in cash outflow. As the company grows and recruits more personnel, buys, or leases additional real estate, and needs more supplies, it is essential to evaluate cash expenses as they will very likely increase. 

What are non-cash expenses?

An expense that does not include any exchange of cash (or payment) is known as a non-cash expense. These expenses are an integral part of an income statement; however, they do not impact cash inflows and outflows of a business. Companies can estimate these costs to better manage their operating cash flow. 

Examples of non-cash expenses: 

• Depreciation:

Depreciation refers to a reduction in asset value because of usage and wear and tear. Tangible assets will depreciate based on company policy and the nature of the asset. Standard depreciation duration is between 3-7 years. The journal entry recorded for depreciation typically looks like:

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          Depreciation expense Dr.

               Accumulated depreciation a/c Cr.

• Amortization:

Amortization refers to writing down an intangible asset or a loan. An asset value is reduced over the lift of a loan or an intangible asset which can usually range anywhere from six to fifteen years. Here's an example journal entry of amortization:

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          Amortization expense Dr.

               Accumulated amortization a/c Cr.

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• Stock-based compensation expense:

Stock compensation (SBC) refers to companies that grant stock incentives to employees to hire and retain talent. SBC can be in the form of stock options, restricted stock units (RSUs), and employee stock purchase plans (ESPP) and part of the employee’s compensation package. These compensation strategies slightly vary as noted below. 

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1. Stock options: A company grants employee stock options that are exercisable in the future at a set price (strike price). If the value of the stocks rises above the strike price, the employee is “in the money” and will exercise the options. If the stock price of the company is lower than the strike price, you’re “out of the money”. You will not exercise the options and options become worthless in this scenario. 

2. RSUs: A company grants restricted stock units to employees usually quarterly or annually as a part of an employee compensation package. Employees own the share on the vesting date. RSUS can then be sold in the public market for cash. 

3. ESPP Plans: Companies offer an ESPP plan where employees can purchase the company stock at a discount. This is recorded through regular payroll deductions. The shares are purchased by employees through after-tax deductions for a given pay period. This can be a valuable benefit offered by a company and offer benefits of stock appreciation to the employee. 

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All the above methods result in non-cash expenses on the income statement. The journal entry recorded at the grant date for stock compensation is: 

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          Stock compensation expense Dr.

               Equity-Paid in Capital Cr.

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• Unrealized gains/losses:

Unrealized gains and losses are usually referred to as not real or paper gains and losses. These amounts are not actual gains/losses as the underlying asset has yet to be sold. There is no ownership or cash exchange. This item on the income statement captures the value of the asset at quarter end to show the unrealized gain or loss for the asset held. The journal entry recorded for unrealized gains or losses is:

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          Unrealized gains/loss Dr.

               Investments a/c Cr.

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• Bad debt expense:

Bad debt is an estimate of accounts receivable that management believes is uncollectible. It is usually evaluated and recorded quarterly in the accounting books. This estimate is recorded as a reduction to net income. These accounts are likely unrecoverable and will never convert to cash, even though revenue for these accounts is recorded on the books. Bad debt expense is often estimated as a percentage of sales or a percentage of receivables. Here's the journal entry for a bad debt expense:

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          Bad Debt expense Dr.

               Bad Debt allowance a/c Cr.

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• Asset impairment:

An impairment is a reduction in asset value. It applies to fixed and intangible assets. An asset on the books is adjusted down to its current fair value. Assets are evaluated against current marketing pricing quarterly or annually and written down and properly reflected on the balance sheet. Asset impairment is recorded as noted below:

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          Loss on impairment Dr.

               Accumulated depreciation/amortization Cr.

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• Deferred taxes:

Deferred tax assets and liabilities are created due to temporary differences between IFRS/GAAP tax reporting and actual income taxes paid in each country. When the book income (GAAP or IFRS) exceeds the taxable income a deferred tax asset is created. When tax income exceeds the book income a deferred tax liability is created:

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           Deferred tax asset Dr.

                Income tax expense Cr.

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           Income tax expense Dr.

                 Deferred tax liability Cr. 

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Operating cash flow is a key metric to assess a company's operational efficiency, and ability to grow and reinvest earnings. Operating cash flow is calculated as shown below: 

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Net Income (per the income statement) 

     - Impacts of non-cash transactions

     - Change in working capital (assets/liabilities) 

= Operating cash flow

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The cash flow statement becomes an indispensable tool within this context. This financial statement provides a detailed breakdown of the cash inflows and outflows from operating, investing, and financing activities, offering deeper insights into the company's liquidity and long-term viability. Understanding the impact of non-cash transactions and analyzing the cash flow statement can enable a company to achieve positive operating cash flow.

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It is also important to understand the impact of non-cash transactions and how they can enable a company to achieve positive operating cash flow. Below is a summary of non-cash components of four Big Tech companies for 2023.

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As shown below the biggest non-cash expenses for big tech and startups are usually stock compensation expenses and amortization and depreciation. As tech companies usually don’t need more physical space or assets for expansion, depreciation costs are likely to lower over time. For large tech companies stock compensation expense is likely to increase over time as companies try to retain and hire top talent within key growth areas.  

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Below is a view of Alphabet and Meta’s non-cash items - 

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Below is a view of Microsoft and Amazon’s non-cash items-

(Source: 2023 10K filing)

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Non-cash expenses are critical to both income statements and operating cash flow. Certain non-cash expenses such as depreciation can reduce the company’s taxable and net income, thereby increasing the operating cash flow. For companies in the early stages of scaling up, being able to extract the value from non-cash expenses is crucial as it can help them strategically reinvest into new products, pipelines, opportunities, and employees.

How to evaluate non-cash expenses? 

Tech companies are often not profitable in the early years; they typically achieve profitability in later stages. However, it is critical to evaluate operating cash flows in addition to profitability. Whether you’re an investor evaluating a company’s performance, a finance professional within a company, or a C-suite executive, here are some key questions to consider when evaluating cash and non-cash expenditures:

• Is the company generating a positive cash flow? 
• Is net cash provided from operating activities increasing YoY? 
• What is the impact of non-cash expenses YoY? 
• How is the company managing non-cash vs. cash expenses and reinvesting in the business? 

The answers to these questions should provide data points that can be investigated further to gain a stronger understanding of the company’s financial position.

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