Although, pafalafa-ga has provided a very nice link but I undertook
this assignment because we get confused in calculating the operating
cash flow due to the different methods of calculation in accounting
and finance. Let me provide a very simple explanation of the two.
Before discussing how to calculate Operating Cash Flow (OCF), let us
first see what we mean by ?cash flow?? By cash flow we simply mean the
difference between the number of dollars that came in and the number
that went out of the company.
A simple example of cash flow is the cash that is paid to creditors
and stockholders (cash outflow) and cash that is generated by selling
goods (cash inflow).
*WARNING! The standard accounting financial statement, ?Statement of
Cash Flows? is concerned with somewhat different issue and should not
be confused with cash flow and operating cash flow.
OPERATING CASH FLOW
Operating cash flow can simply be described as the cash flow that
results from the firm?s day to day activates of producing and selling.
Note the difference between the definition of cash flow and operating
cash flow. Cash flow consists of cash that comes in and goes out of
the company while operating cash flow consists of the cash that comes
in and out of the company from the firm?s daily activities of
producing and selling.
Confused? Ok! You will understand the difference as we try to
calculate the operating cash flow of a company.
CALCULATING OPERATING CASH FLOW
Let us assume that the Income Statement of the US Corporation looks likes this:
2003 Income Statement
($ In Millions)
Net Sales $1,509
Cost of goods sold 750
Earnings before Income & Taxes $ 694
Interest Paid 70
Taxable Income $ 624
Net Income $ 412
Addition to retained earnings 309
OPERATING CASH FLOW ACCRODING TO ACCOUNTING DEFINITION
In Accounting, the operating cash flow can simply be calculated as Net
Income plus depreciation. Thus, from above example the operating cash
flow of the US Corporation is $412 + $65.
Note that we add the depreciation expense of $65 because we didn?t pay
any cash nor we got any cash from anyone, therefore there was no cash
inflow or outflow.
OPERATING CASH FLOW ACCRODING TO FINANCIAL DEFINITION
Here is the formula for calculating operating cash flow according to
Earnings before Income & Taxes
Operating Cash Flow
To calculate the operating cash flow (OCF), we first need to calculate
revenues (or Net Sales in some cases) minus the costs.
Notice that costs means everything that we pay in cash (cash outflow).
But in order to calculate the operating cash flows we don?t include
depreciation expense and interest expense as a cost.
Why? Because we don?t pay cash to anyone while calculating
depreciation expense, therefore it is not a cash outflow. We also
don?t include interest expense because interest is paid out when we
finance anything and since the cash we pay as an interest does not
originates from the daily activities of buying and selling.
Yes, we include taxes because taxes are paid in cash and originate
from the daily activities of the firm.
Now let us calculate the operating cash flow of US Corporation (see
sample income statement, above).
We know that the Earnings before Income and Taxes are 694 Mil. We will
than add depreciation which is 65 Mil (We add depreciation from the
balance sheet because we didn?t pay anyone cash). Finally we will
deduct taxes that are 212 Mil.
2003 Operating Cash Flow
Earnings before Income and Taxes $694
+ Depreciation 65
- Taxes 212
Operating Cash Flow $547
DIFFERNCE BETWEEN ACCOUNTING AND FINANCIAL OPERATING CASH FLOW.
The only main difference between the accounting and financial
operating cash flow definition is that the interest is not considered
to be an outflow of cash.
WHY CALCULATE OPERATING CASH FLOW?
On a very basic level, an operating cash flow tells us whether or not
a firm?s cash inflows from its business operations are sufficient to
cover its cash outflows. Therefore, a negative operating cash flow is
often a sign of trouble.
I hope this will help. Please clarify, if you are not satisfied. I
will explain everything that is needed to be explained.