Operating Cash Flow: The Key to Sustainable Business Growth

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Cash_Flow-01_generated-by-operating cash flow activities.

History

Definition

Common types

Direct operating cash flow

Direct operating costs are costs that are directly tied to a company’s operations or manufacturing process. Costs such as raw materials, labor, and equipment involved in the manufacturing of goods or services are included. These costs are often variable and vary with output level.

They are critical for businesses to measure since they can have a substantial impact on the company’s profitability. Companies can raise their profit margins and become more competitive in their respective markets by managing and cutting direct operating costs.

Formula

Calculation

Assume we have XYZ Inc. and wish to compute its direct operating cash flow for the fiscal year ending December 31, 2022.

Cash Inflows from Operating Activities:

• Sales revenue: $500,000

• Interest income: $10,000

• Cost of goods sold: $250,000

• Operating expenses: $150,000

• Interest expense: $5,000

• Income tax expense: $50,000

Step 1: Determine Cash Inflows
The first step is to figure out how much money comes in from operating activities. In this example, we have $500,000 in sales revenue and $10,000 in interest income.

As a result, the overall cash inflows from operating activities are as follows:

Cash Inflows from Operating Activities = $500,000 + $10,000 = $510,000

Step 2: Determine Cash Outflows
The cash outflows from operating activities for XYZ Inc. for the fiscal year ended December 31, 2022 can therefore be calculated.

In this example, we have a $250,000 cost of goods sold, a $150,000 operating expense, a $5,000 interest charge, and a $50,000 income tax expense.

As a result, the overall cash outflows from operating activities are as follows:

Cash Outflows from Operating Activities = $250,000 + $150,000 + $5,000 + $50,000 = $455,000

Step 3: Determine the Direct Operational Cash Flow.
Lastly, we can use the formula to compute XYZ Inc.’s direct operating cash flow for the fiscal year ending December 31, 2022:

Direct Operating Cash Flow = Cash inflows from operating activities – Cash outflows from operating activities

Direct Operating Cash Flow = $510,000 – $455,000 = $55,000

As a result, XYZ Inc.’s direct operating cash flow for the fiscal year ending December 31, 2022 is $55,000.

Examples

Labor: Wages, salaries, and benefits paid to personnel directly participating in the manufacturing process are referred to as labor.

Equipment: The expense of purchasing and maintaining machinery and tools needed in the manufacturing process.

Utilities: The cost of utilities used in the manufacturing process, such as power and water.

Raw materials: The cost of obtaining and delivering the raw materials required to manufacture a product.

Packaging costs: Packing costs include the materials used to protect and transport the finished product.

Rent: The expense of renting the facilities required to run the manufacturing process.

Indirect operating operating cash flow

Indirect operational cash flow is a way of calculating a company’s operating cash flow by adjusting net income for non-cash factors such as depreciation and amortization, changes in working capital, and other non-cash elements. It is one of two generally used methods for calculating operating cash flow, the other being the direct method.

The indirect technique begins with the company’s income statement’s net income figure and then adjusts for non-cash expenses and changes in working capital accounts to arrive at the operating cash flow.

Formula

Indirect operating cash flow= Net Income + Non-Cash Expenses – Changes in Working Capital

Calculating

Assume we have XYZ Corp and wish to compute its indirect operating cash flow for the fiscal year ending December 31, 2022.

We have the following information:

• Net earnings: $100,000

• Depreciation Charge: $25,000

• Accounts payable: $50,000 (starting balance), $60,000 (ending balance)

• Accounts Receivable: $20,000 (starting balance), $30,000 (ending balance)

• Inventory: $75,000 (total starting balance), $60,000 (ending balance)

Step 1: Determine Non-Cash Costs
The first step is to figure out the non-cash expenses, which include depreciation. The depreciation expense in this scenario is $25,000.

Step 2: Determine Working Capital Changes
Then we must compute the changes in working capital. The difference between current assets and current liabilities is referred to as working capital.

In this example, we have the following working capital:

Accounts Receivable: $60,000 – $50,000 = $10,000 increase

Accounts Payable: $30,000 – $20,000 = $10,000 increase

Inventory: $60,000 – $75,000 = $15,000 decrease

To calculate the total change in working capital, we add the changes in current assets and subtract the changes in current liabilities:

Total change working capital= $10,000 + $15,000 – $10,000 = $15,000

Step 3: Determine the Indirect Operating Cash Flow.
We can now use the procedure to compute XYZ Corp’s indirect operating cash flow for the fiscal year ending December 31, 2022:

Net Income + Non-Cash Expenses – Changes in Working Capital

$100,000 + $25,000 – $15,000 = $110,000

Therefore, the indirect operating cash flow for XYZ Corp for the year ended December 31, 2022 is $110,000.

Examples

Depreciation and amortization: Depreciation and amortization are non-cash expenses that are subtracted from net income to calculate operating cash flow. These costs indicate the depreciation of long-term assets such as property, plant, and equipment, as well as intangible assets such as patents and trademarks.

Accounts receivable changes: Accounts receivable are funds owing to a company by its customers for goods or services sold on credit. An increase in accounts receivable represents uncollected cash, which is a financial outflow. A decrease in accounts receivable represents collected cash, which is a cash inflow.

Accounts payable changes: Accounts payable reflect money owed to vendors for products or services acquired on credit. Cash influx is represented by an increase in accounts payable, which reflects cash that has not yet been paid. A drop in accounts payable represents paid cash, which is a financial outflow.

Deffered taxes: Deferred taxes are another non-cash item that can have an influence on operating cash flow. Tax deferral tactics can be used by businesses to reduce their taxable income in the current year, resulting in a deferred tax liability. In a subsequent year, the deferred tax liability is reversed, resulting in a non-cash expense or benefit.

TypeProsConsExamples
DirectSimple calculation, accurate reflection of operating performanceCan be difficult to separate operating expenses from non-operating expensesA manufacturer’s sales revenue minus the cost of goods sold
IndirectAdjusts for non-cash expenses and changes in working capitalRequires adjustments to net income, which can be subjectiveA retailer’s net income plus depreciation and amortization expenses

Total operating Cash Flow

Here’s a step-by-step example of total operating cash flow calculation:

Step 1: Calculate the Net Income
The first step in calculating operating cash flow is determining the period’s net income. Assume Luis1k Company’s net income for the fiscal year ending December 31, 2022 was $500,000.

Step 2: Recover Non-Cash Expenses
Then, any non-cash expenses must be added back to the net income. Depreciation, amortization, and deferred taxes are all examples of this.

Assume Luis1k Company had a $100,000 depreciation expense for the year.

• Net Income = $500,000

• Depreciation Expense = $100,000 = $600,000

Step 3: Account for Variations in Working Capital
The operating cash flow must then be adjusted to account for changes in working capital. This includes adjustments to accounts receivable, payable, and inventory.

Assume the company experienced the following changes in working capital:

• Accounts Receivable were reduced by $50,000.

• Accounts Payable: $25,000 increase

• Inventory has been increased by $10,000.

To account for these changes, subtract the decrease in accounts receivable from the cash flow and add the increase in accounts payable and inventory.

Net Income + Non-Cash Expenses = $600,000

Decrease in Accounts Receivable = $50,000

Increase in Accounts Payable = $25,000

Increase in Inventory = $10,000 = $585,000

Step 4: Completing the Calculation
Finally, we calculate Luis1k Company’s total operating cash flow for the fiscal year ending December 31, 2022.

Operating Cash Flow =$585,000

Importance

Operating cash flow is an important financial metric because it provides valuable insight into a company’s ability to generate cash from its core operations.

Following are some of the primary reasons for the importance of operating cash flow:

Financial Health Indicator: Operational cash flow is a critical measure of a company’s financial health. It demonstrates if a company generates enough cash from core operations to fund day-to-day operations, pay bills, and invest in growth prospects. A positive operating cash flow suggests that a corporation is earning enough cash to support its business operations over time.

Capital Allocation Flexibility: A corporation with a high operating cash flow has more capital allocation flexibility. It can reinvest in the company, pay dividends, repurchase stock, or pay down debt. Its adaptability can assist a corporation in navigating difficult economic situations or capitalizing on growth possibilities.

Future Cash Flow Prediction: Operational cash flow can also be used to forecast a company’s future cash flows. Investors and analysts can make educated projections about a company’s future financial performance by evaluating historical operating cash flow trends.

Compare financial performance: Operational cash flow can be used to compare a company’s financial performance to that of its industry peers. This data can be used by investors and analysts to discover organizations that generate more cash from their activities, indicating superior financial success.

Balance sheet

Quaterly Cash Flow statment Tesla 2022- Operating cash flow: Depreciation/Depletion, Amortization, Deffered Taxes, Non-cash items, cash receipts, Cash payments, cash taxes paid, cash interest paid, changes in working capital.
Source: Investing.com

The cash flow statement is divided into multiple categories, with operating cash flow being the biggest one.

Operating cash flow contains multiple sizes on the balance sheet:

Depreciation/Depletion

Depreciation is the loss of a tangible asset’s value throughout its useful life as a result of wear and tear, obsolescence, or other factors. On the other hand, depletion refers to the decrease in the value of a natural resource such as oil, gas, or minerals as a result of extraction or use.

These are some examples of depreciation:

• A corporation spends $100,000 on a machine that it expects to last ten years. Every year, they would deduct $10,000 for depreciation.

• A corporation spends $500,000 on a building that it expects to endure 30 years. Each year, they would incur a depreciation expenditure of $16,667.

Some examples of depletion include:

• An oil and gas company spends $1 million on a well that will yield 100,000 barrels of oil. The depletion cost is $10 per barrel of oil once the oil is withdrawn.

Amortization

Amortization is the systematic allocation of the cost of intangible assets over the useful life of those assets. Patents, trademarks, copyrights, and goodwill are examples of intangible assets.

Examples of amortization include:

• A corporation spends $500,000 on a patent that it expects to last ten years. Every year, they would deduct $50,000 for amortization.

• A corporation spends $200,000 on a trademark that it expects to last 5 years. Each year, they would incur a $40,000 amortization fee.

Deffered taxes

Deferred taxes are the difference between taxes payable or receivable in the current period and taxes payable or receivable in subsequent periods.

Deferred taxes could include the following:

• A company’s assets have a transient gap between book and tax depreciation. As a result, it has a deferred tax burden that will be realized at some point in the future.

• A business has a net operating loss that it can carry forward and utilize to offset future taxable gain. As a result, it has a deferred tax asset that will be recognized at some point in the future.

Non cash items

Non-cash items are those that do not require the exchange of money. These items may continue to have an influence on the company’s financial statements and cash flows.

Non-cash items could include the following:

• Expenses for depreciation and amortization.

• Expenses for stock-based compensation.

Cash receipts

The inflow of cash into a business is referred to as cash receipts.

These are some examples of cash receipts:

• Customers’ cash payments for the sale of goods or services.

• Profit from the selling of investments.

Cash payments

Cash payments are the outflows of cash from a business.

Cash payments could be made in the following ways:

• Suppliers are paid in cash for inventory or raw supplies.

• Employee salary and benefits are paid in cash.

Taxes paid in cash

The actual amount of taxes paid in cash during the reporting period is referred to as cash taxes paid.

Cash taxes may be paid in the following ways:

• The government receives federal income taxes.

• Income taxes paid to the state government

These are some examples of cash interest payments:

• Interest paid on a bank or financial institution loan.

Cash interest paid

The actual amount of interest paid in cash during the reporting period is referred to as cash interest paid.

These are some examples of cash interest payments:

• Interest paid on a bank or financial institution loan.

• The interest paid on the company’s bonds.

Changes in working capital

The changes in the company’s current assets and liabilities from one reporting period to the next are referred to as changes in working capital.

Examples of working capital fluctuations include:

• An increase in accounts receivable, which is money owing by customers to the company for goods or services sold on credit. Because the company has not yet received the cash, this would result in a drop in working capital.

• A reduction in accounts payable, which is money due to suppliers by the company for goods or services acquired on credit. This would result in an increase in working capital because the company would have more cash on hand to use for other purposes.

Positive operating cash flow

This indicates that a company’s operations generate more cash than it spends on them. Generally, this is a positive sign because it indicates that the company has enough cash to cover its operating expenses and potentially invest in growth opportunities.

Example 1: A manufacturing company has a positive operating cash flow because it can sell its products at a price that covers its production costs while also generating extra cash. This enables the company to pay its employees, suppliers, and other expenses while also investing in new equipment and technology to increase efficiency.

Example 2: A software company has a positive operating cash flow because it can sell its software at a high margin while incurring relatively low operating expenses (such as salaries and office rent). This enables the company to generate significant cash from its operations, which it can then invest in new products and enter new markets with.

Negative

This indicates that a company spends more money on its operations than it earns. While this is not always a bad sign (for example, a company may be heavily investing in growth opportunities), it can indicate that the company is having difficulty generating enough cash from its core business activities.

Example 1: A startup business has a negative operating cash flow because it is heavily investing in R&D, hiring new employees, and marketing its products. While the company’s operations are not currently generating much cash, it believes that these investments will eventually pay off and lead to long-term growth.

Example 2: A retail company has a negative operating cash flow because it is competing fiercely and cannot sell its products at a high enough price to cover its expenses. The company is forced to borrow money to cover its expenses, which is a red flag for investors because it indicates that the company is struggling to generate enough cash from its operations.

Operating cash flow vs Net Income

MetricDefinitionCalculationDifference
Operating Cash FlowThe cash generated from a company’s core business operations, which reflects the amount of cash a company generates from its day-to-day operations.Net Income + Non-Cash Expenses – Changes in Working CapitalReflects the actual cash generated by a company’s operations, regardless of accounting methods.
Net IncomeThe total amount of profit a company earns after accounting for all expenses and revenue.Total Revenue – Total ExpensesReflects the total profit earned by a company, but does not necessarily reflect the actual cash generated or used.
DifferenceThe variance between operating cash flow and net income.Operating Cash Flow – Net IncomeShows whether a company’s net income is significantly higher or lower than its actual cash flow.

While operating cash flow and net income are both important metrics in analyzing a company’s financial health, they can sometimes paint contradictory pictures. Operating cash flow accounts for non-cash expenses (such as depreciation) and changes in working capital, whereas net income reflects a company’s total profit.

The distinction between operating cash flow and net income can reveal whether a company’s reported profit differs significantly from its actual cash generation.

Free operating cash flow

The cash flow available for distribution to all stakeholders, including investors and creditors, after accounting for all capital expenditures required to operate or expand the business, is referred to as free cash flow (FCF). It is a popular indicator used by analysts and investors to assess a company’s financial health and potential for growth.

The free cash flow formula is as follows:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Where:

• Operating Cash Flow = Earnings Before Interest and Taxes (EBIT) + Depreciation and Amortization – Taxes – Change in Working Capital

• Current Liabilities = Short-term debts and obligations that are due within one year

Assume XYZ Corporation has the following financial data for the fiscal year:

• EBIT: $500,000

• Depreciation and amortization: $100,000

• Taxes: $100,000

• Working capital change: $50,000

• PP&E purchase: $200,000

• Intangible Asset Purchase: $50,000

To calculate FOCF for XYZ Corporation, we need to follow these steps:

Step 1: Evaluate Operating Cash Flow:

Operating Cash Flow = EBIT + Depreciation and Amortization – Taxes – Change in Working Capital Operating Cash Flow

= $500,000 + $100,000 – $100,000 – $50,000

Operating Cash Flow = $450,000

Step 2: Determin Capital Expenditures:

Capital Expenditures = Purchase of PP&E + Purchase of Intangible Assets Capital Expenditures

= $200,000 + $50,000= $250,000

Step 3: Calculate Free Operating Cash Flow

FOCF = Operating Cash Flow – Capital Expenditures

FOCF = $450,000 – $250,000 = $200,000

As a result, XYZ Corporation has a $200,000 free operating cash flow for the year.

Operating cash flow to current liabilities ratio

The operating cash flow to current liabilities ratio is a financial ratio that measures a company’s ability to pay off its short-term debts with its operating cash flow.

This ratio is derived by dividing the operating cash flow of a corporation by its current liabilities.

Operating cash flow to current liabilities ratio is similar to the free cash flow to current liabilities ratio, which measures a company’s ability to repay its short-term debts. The fundamental distinction between the two ratios is that the operating cash flow to current liabilities ratio only considers cash earned from operations, whereas the free cash flow to current liabilities ratio considers both operating and non-operating cash flows.

Operating cash flow to current liabilities ratio is calculated as follows:

Operating Cash Flow to Current Liabilities Ratio = Operating Cash Flow / Current Liabilities

Where:

• Earnings before Interest and Taxes (EBIT) + Depreciation and Amortization – Taxes – Change in Working Capital = Operational Cash Flow

• Current Liabilities = Debts and commitments that are due within a year.

A high operating cash flow to current liabilities ratio implies that a corporation can pay down its short-term debts using its operating cash flow.

On the other hand, a low ratio may suggest that a company is having difficulties servicing its short-term debt obligations using its operating cash flow.

FAQ

The operating cash flow for a project should exclude which one of the following?

When calculating the operating cash flow for a project, it is important to exclude certain expenses and income items that are not directly related to the operations of the project.

The following are the most prevalent items that should be removed from the calculation of operating cash flow:

Interest expenses: Interest expenses are payments paid on loans and other forms of debt that are not directly tied to the project’s operations. As a result, interest expenses should be removed from the computation of operating cash flow.

Income taxes: Income taxes are paid on a company’s profits and are not directly tied to the project’s operations. As a result, income taxes should be removed from the computation of operating cash flow.

• One-time or unusual items: One-time or extraordinary events, such as gains or losses from asset sales or lawsuit settlements, should be removed from the operating cash flow calculation because they are not part of the project’s regular operations.

• Non-cash expenses: Non-cash expenses are accounting expenses that do not entail a cash outlay, such as depreciation and amortization. They should be eliminated from the calculation because they do not involve the usage of cash.

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