- AuthorJack Woerner
BA in Political Science with Emphasis on Social Studies Education at Brevard College, 6 years experience (2 years online) teaching Economics, Personal Finance, APUS Government and more. Certified Gifted/Talented Teacher.
View bio - InstructorLucinda Stanley
Lucinda has taught business and information technology courses, has a PhD in Education, and a master’s degree in business education.
View bio - Expert ContributorSteven Scalia
Steven completed a Graduate Degree is Chartered Accountancy at Concordia University. He has performed as Teacher's Assistant and Assistant Lecturer in University.
View bio
Learn what operating cash flow is and the formula for how to calculate operating cash flow. Discover examples of equations for the different operating cash flow approaches.Updated: 11/21/2023
Table of Contents
- Operating Cash Flow
- Operating Cash Flow Calculations
- Operating Cash Flow Example
- Lesson Summary
- FAQs
- Activities
Operating Cash Flow - A Practical Exercise:
The following exercise is designed to help students apply their knowledge of Operating Cash Flow in a real-life context.
Exercise:
You are an investment analyst at Rich Dough Inc, an investment firm that specializes in value investing. Your manager is in the process of analyzing two competing companies in the aerospace industry (R2D4 and Darth Money) and asks for your help.
These companies have similar amounts of income, but I'm very concerned about cash flows since accrual accounting is easier to manipulate than cash. I'll send you some information. Can you tell me which company produces the most operating cash flow?
You receive the following information (in millions):
| Company | R2D4 | Darth Money |
|---|---|---|
| Total Revenue | 150 | 185 |
| Cost of goods sold | 45 | 65 |
| Other expenses | 35 | 43 |
| Depreciation (included in Other expenses) | 10 | 1 |
Required:
1. Using the above information, compute the net income and operating cash flow for both companies. Which company has the highest operating cash flow?
2. Let's assume that R2D4's expenses did not include taxes, but its tax rate was 10%. What is R2D4's Operating Cash Flow? (Hint: Use the Top-Down Approach)
Solution:
1.
Net Income:
Net Income = Revenue - Cost of goods sold - Other expenses
| Company | R2D4 | Darth Money |
|---|---|---|
| Total Revenue | 150 | 185 |
| Cost of goods sold | 45 | 65 |
| Other expenses | 35 | 43 |
| Net Income | 70 | 78 |
Darth Money has a higher net income.
Operating Cash Flow:
Operating cash flow = Revenue - Expenses + Depreciation
| Company | R2D4 | Darth Money |
|---|---|---|
| Total Revenue | 150 | 185 |
| Less: | ||
| Cost of goods sold | 45 | 65 |
| Other expenses | 35 | 43 |
| Add: | ||
| Depreciation (included in Other expenses) | 10 | 1 |
| Operating Cash Flow | 80 | 79 |
R2D4 has a higher operating cash flow.
2. The formula for calculating EBIT can be given as
EBIT = Revenue - All expenses besides taxes
EBIT = 150 - 45 - 35
EBIT = $70
Taxes = EBIT * Tax rate
Taxes = 70 * 0.1
Taxes = $7
Operating cash flow = EBIT - Taxes + Depreciation
Operating cash flow = 70 - 7 + 10
Operating cash flow = $73
The answer is $73.
What is included in net operating cash flow?
The net operating cash flow is the cash flow after all costs and expenses have been accounted for. Costs or expenses can be taxes, depreciation, or interest.
What is meant by operating cash flow?
Operating cash flow means the revenue brought in by a company's normal operating activities. The operating cash flow focuses on the short-term income and expenses.
Why is operating cash flow important?
A business can check the progress of their business when they properly calculate operating cash flow. A business can also monitor their finances to make sure they are operating smoothly.
How do you calculate operating cash flow?
There are three primary methods to calculate operating cash flow. One could use the bottom-up approach, top-down method, or the tax shield approach.
Table of Contents
- Operating Cash Flow
- Operating Cash Flow Calculations
- Operating Cash Flow Example
- Lesson Summary
What is operating cash flow? In business, the operating cash flow (OCF) definition is the money a company brings in through their normal operations during a time period. Operating cash flow includes any money involved in a cash transference. Cash transference is any transfer of money to someone including income and the value of non-cash assets. OCF adjusts for depreciation of capital goods. Businesses can use operating cash flow to help make important financial decisions. Analyzing the cash flow is also an important indicator in tracking the progress of a business and getting an overview of its financial status. Operating cash flow decisions are important for financial sector positions like financial analysts, investors, or business finance managers, but is not as useful for vendors. Vendors are not involved in a business's financial decisions and only need to be paid for the service they provide. They are not invested in the financial wellbeing of a company like analysts, investors and managers would be. On the other hand, financial analysts use OCF data to determine the health of a certain business sector or the overall economy. Investors need to know the OCF of a business in which they may want to invest their money. Finally, financial managers are responsible for their company's money management and to report accurate accounting data using OCF.
 |
To calculate OCF, accountants and business need to pull data from various financial statements. Financial statements can include general financial information like cash flow, expenses, investments, and income statements. Financial statements are financial reports that show the business's income source and income breakdown. Income statements are used to calculate operating cash flow. Income statements show the profit and loss during a time period. With this information businesses can determine their net profit and cash flow. Net income is the revenue earned by an individual or business minus the expenses and costs. Net income and cash flow are both used in various calculations to determine operating cash flow for a company.
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By using an operating cash flow formula, it is possible to calculate the operating cash flow of a business. There are various methods to find the net operating cash flow within a closed business system. The top-down approach, bottom-up approach and tax shield approach are the most commonly used formulas.
 |
Top-Down Approach
The top-down approach, also known as top-down forecasting, calculates operating cash flow by adding up all the transactions listed in the business activity. The first step of the top-down approach is to begin adding up cash receipts (sales) on the top and working down to the cash payments (costs). The top-down approach is one of the most recommended methods because it is easier to track for accounting purposes. The top-down approach offers clearer steps in tracking cash sources and uses. This approach also serves a business well when reporting their financial statements.
The top-down approach formula is broken down in three steps:
- Sales - expenses - depreciation = EBIT
- EBIT x Tax rate
- OCF = EBIT - tax paid + depreciation
Using the top-down approach, business accountants can figure out how to find EBIT. EBIT means earnings before interest and tax. This can be helpful when a business is forecasting their profit earnings. This approach also helps in calculating depreciation of capital assets. Depreciation is the loss of value of a capital good overtime that can be written off on tax reporting. Depreciation is not listed as revenue and is a method to spread out the value of capital goods overtime. When calculating for EBIT, revenue is left out. EBIT calculations usually involve revenue, depreciate, and sales.
Bottom-Up Approach
The bottom-up approach is the opposite of the top-down approach. The bottom-up approach begins with a business adding up the net income first. Then, the business adds the depreciation value to the net income. Net income is total income earned - any costs, taxes, or interest or any other expenses.
The bottom-up operating cash flow equation is Cash flow = Net income + depreciation.
Tax Shield Approach
The tax shield approach is a method used for businesses to reduce their taxable income. This approach is also known as the depreciation tax shield formula.
A business or individual will use the tax shield approach to take advantage of tax breaks, tax shelters, allowable deductions, tax credits, and any other tax reducing tool. There are many types of tax shield examples such as:
- Medical expenses
- Interest payments
- Charitable contributions
- Depreciation
- Business investments
The tax shield approach helps businesses and individuals lower their tax burden and helps them save money.
The tax shield formula is OCF = (Sales - Costs) X (1 - Tax rate) + Depreciation X Tax rate
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A business should be able to use any operating cash flow calculating method and produce the same answer or find the same results.
- Bottom-up Approach Example
A business wants to calculate their operating cash flow using the bottom-up approach. This is their financial statement data:
- Net income = $7,000
- Expenses = $2,000
- Interest = $600
- Depreciation = $4,000
Bottom-up approach for reference: Cash flow = Net income + depreciation
For this example, the formula would look like: OCF = 7,000 + 4,000. Expenses and interest would not be added into the formula. $11,000 is the operating cash flow figure
- Top-down Approach Example
Using the same scenario from above, a business wants to calculate their operating cash flow using the top-down approach. Their financial statement includes:
- Sales = $17, 600
- Expenses = $2,000
- Taxes and Depreciation = $4,000
- Corporate tax rate = 36.36%
Top-down approach formula:
Sales - expenses - depreciation = EBIT
EBIT x Tax rate = tax paid
OCF = EBIT - tax paid + depreciation
For this example:
17,000 - 2,000 - 4,000 = 11,000
11,000 x 36.36% = 3999.6 (round to 4,000)
OCF = 11,000 - 3999.6 + 4000
OCF = $11,000
- Tax Shield Approach Example
A business now wants to use the tax shield approach to calculate their OPC. Their financial statement with tax shield approach is:
- Sales = $17,600
- Deductible expenses = $2600
- Corporate tax rate = 36.36%
- Depreciation = $4,000
The tax shield formula OCF = (Sales - Costs) X (1 - Tax rate) + Depreciation X Tax rate. For this example:
The first step would be to plug in the numbers: OCF = (17600 - 2600) x (1-36.36%) + 4,000 x 36.36%
Next step breaking the equation down further: 15000 x .6364 + 1454.4 = 11,000.4 OCF (Tax accountants often round to the whole number instead of leaving decimals)
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Operating cash flow (OCF) is the cash generated by a business from its regular operating activities. Businesses calculate operating cash flow in order to see how their business is progressing and to track their financial wellbeing. Calculating OCF is important for business leaders, investors, and financial analysts but OCF is not as useful for vendors since a company's OCF calculations is not used for them. Financial statements, more specifically income statements, are used to help calculate OCF. The most used operating cash flow formula is: Operating Cash Flow = Net Income + Non-Cash Expenses - Increase in Working Capital.
There are three other methods to calculate OCF and each type has its own operation cash flow equation : Top-down approach, bottom-up approach and tax shield approach. The top-down approach adds up all the sales first and then subtracts the expenses. This approach also helps solve earnings before interest and tax (EBIT). Part of calculating EBIT is figuring out depreciation which is the loss of value of capital equipment overtime. When calculating for EBIT, revenue is left out. The other method is the bottom-up approach, and it starts with net income and adds depreciation. The third method is the tax shield approach which helps business reduce their taxable income.
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Video Transcript
Cost of Running a Business
Do you have a budget? You know, something that shows you how much money you have and what your expenses are? Do you use it to figure out if you have enough income to afford to buy a new car, or a used car, or if you just have to keep taking the bus?
Businesses have something similar, but they call it an operating cash flow. An operating cash flow (OCF) is the money or cash that is used by a business to manage its day to day operations. OCF concerns the actual transference of money to and from the business. Investors will take a look at a business's operating cash flow to determine if the business is making enough cash to cover its costs with enough left over for things like growth, research and development, paying dividends, and paying back debt. And a business will take a look at operating cash flow to see if they have the money to expand their business either by cash or through borrowing. For example, they need to know if they buy that one million dollar piece of equipment, they will have enough money to pay it back over time.
Three Approaches
We have to remember that cash flow is not the same as a business's net income. The income statement, which calculates net income, shows the business's worth at a given point in time. However, when businesses report their net income they are including any transactions that did not have an actual transference of cash, such as depreciation. Remember, the OCF refers specifically to cash transference.
There are three different approaches businesses use to calculate their operating cash flow: bottom-up, top-down, and tax shield. Let's look at each of these approaches.
The bottom-up and top-down approaches both start with the items on the income statement. The bottom-up approach begins at the bottom of the income statement, with net income, and adds back to the net income any amounts for depreciation. Depreciation is a reduction in the worth of equipment or machinery for each year it's used. This is not a cash transaction, it is simply a way to spread out the value of that equipment over time, indicating that the machine you bought six years ago is not worth as much today. So the bottom-up formula to calculate the businesses operating cash flow looks like this: Net income + depreciation.
The top-down approach also begins with numbers from the income statement. However, it starts with the items at the top. The top-down formula to calculate the business's operating cash flow comes in three parts. Your first calculation: Sales - expenses - depreciation = EBIT. Then you use that figure for your second calculation: EBIT x tax rate = tax paid. Finally, you put it all together to get your OCF: EBIT - tax paid + depreciation.
Let's break that down. The first item on the income statement is revenue, or cash from sales, and subtracted from that are the expenses and depreciation. This gives the business's earnings before interest and taxes (EBIT). Then you have to calculate the tax paid, which you do by multiplying the business's tax rate by EBIT. The tax paid is then subtracted from the EBIT, and then the depreciation is added back in.
It's important to note one key difference between the bottom-up and top-down approaches. In the bottom-up approach, the business starts with their net income figure, then subtracts out any non-cash items like depreciation. This eliminates the need to add them in then subtract them out like you do in the top-down approach because the tax payment is already accounted for.
The tax shield approach is actually similar to the top-down approach because it considers sales, expenses, depreciation and taxes, since paying taxes has an impact on available cash for operating the business. The formula looks like this: (Sales - expenses) (1 - tax) + depreciation x tax. Again, since depreciation affects the amount of tax a business pays but is not a cash transfer, it has to be accounted for and then taken away.
That's all great, but what does this actually do for the business?
Barnaby Business Example
Let's take a look at Barnaby Business. Their income statement for 2015 shows sales of $30,000, expenses of $14,000, depreciation of $6,000 and a tax rate of 28%. Their net income = $7,200.
The bottom-up approach shows that the operating cash flow = net income + depreciation. The top-down approach shows that finding operating cash flow takes more than one step: sales - expenses - depreciation to get the EBIT. Then, EBIT x tax rate = tax paid. And finally, EBIT - tax paid + depreciation. The tax shield approach takes (sales - expenses) (1 - tax) + (depreciation x tax) to find the OCF.
No matter which approach is used, we can see the business has an operating cash flow of $13,200. This is how much money Barnaby's Business has left over to grow the business either through research and development or by purchasing additional machinery.
Lesson Summary
Operating cash flow (OCF) is the actual money that a business has to run its day-to-day operations. It considers the cash that flows into the business in the form of revenue and the cash that flows out of the business in the form of expenses. It represents a picture of the solvency of a business irrespective of depreciation or other non-cash transactions that are included on the income statement. Investors can see by looking at a business's cash flow if the business has enough cash inflow to cover their expenses and if there is enough cash for the business to grow, conduct research and development, pay dividends, and pay back any loans. Businesses use OCF to decide if they are ready to expand operations. Anyone interested in seeing if a business has sufficient cash to cover expenses and to grow the business would use operating cash flow.
Three different ways to calculate OCF are the top-down, bottom-up, and tax shield approaches. The top-down and bottom-up approaches rely on information in the income statement. The tax shield approach is similar to the top-down approach. It takes into account sales, expenses, depreciation, and taxes. No matter which approach is used, the resulting OCF should be the same.
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