The Capex cash driver of 0.35 in the example above may sound like a high proportion, but remember that the assets acquired have depreciable lives. If a particular asset has a seven-year depreciable life for both tax purposes (IRS depreciation table) and financial reporting (your accountant’s judgment), for example, the 0.35 ratio, though fully expended this year, is expensed through the process of
depreciation at only one-seventh of that per year on average. The cash-flow impact of buying that capital asset is far more negative (by 6 to 1) in cash terms than in profit terms. Actually, it is a little more complicated than that because the depreciation is tax deductible on an accelerated basis, so the difference in cash and profit terms isn’t quite as bad as 6 to 1.

Although depreciation is not a cash expense, it is fortunate-ly deductible as an expense for tax purposes. This makes thecash-flow implications of depreciation a little tricky to sort out.For income-statement and income-tax purposes, we use depreciation expense–a way to recover andallocate the original cost of the asset. Butfor cash-flow purposes, we ignore depreciationper se because it is a noncash cost.For cash-flow purposes, we use actual cash expenditures made when the capital asset was acquired.

It is important to understand that the allocated cost called depreciation is often different for income-statement purposes than it is for tax purposes. You actually have two sets of books. Forfinancial-statement purposes, depreciation is usually pretty much the same year to year for a given set of assets. For income-tax purposes, you depreciate faster—that is, more of the asset’s cost is allocated proportionally to the earlier years of its life than to the later years. Since depreciation is an expense, that means more expense and hence less profit in the earlier years. Less profit, of course, means lower taxes—so depreciation acts as a tax shelter. Here’s the rub, though. In subsequentyears, the size of the shelter shrinks and you wind up with a lower depreciation expense. This translates to more profit and higher taxes in those later years of the asset’s depreciable life.Truly, there is no free lunch, except that you did have what amounts to a free loan from the  government for a while in an amount equal to the taxes postponed by the use of accelerated depreciation.

Taken From : Cash Rules