Operating Cash Flow - Managing Cash Flows Generated from Business Operations
The Operating Cash Flow (Cash Flows from Operations) measures how further away Cash Flow is from the company's reported Net Income or Operating Income. Under the Generally Accepted Accounting Principles (GAAP), companies can report good Net Income numbers even though their cash flows are poor due to entries such as Accrued Revenues, etc. In simpler terms, Operating Cash Flow is a verification of quality of the company's reported earnings. Some financial experts argue Operating Cash Flow is a better tool of evaluating earnings than Operating or Net Income because a company can show positive net income but still not have enough cash to meet its debt covenants & obligations such as bonds payable, rent expense, salaries expense, etc. There are 2 formulas for calculating the Operating Cash Flow:
1) Cash Flow from Operations =
2) Cash Flow from Operations =
Differences between Operating Cash Flows and Reported Earnings indicates large amounts of non-cash expenses such as amortization expense, goodwill impairments, etc. If a company reports high earnings but with negative operating cash flows, this presents a red flag that it may be using aggressive accounting techniques that could mislead investors & public using the financial statements of the company.
Operating Cash Flow is sometimes referred to as Free Cash Flow because this cash is 'Free' to be paid back to the suppliers of capital (shareholders and creditors).
Accounting Procedure for Calculating Free Cash Flows
1) Start with total Annual Revenues and subtract Cash expenses & Depreciation to calculate Earnings Before Interest & Taxes (EBIT). EBIT is also referred to as operating income as it is earnings before interest expense & taxes are paid.
2) Calculate Earnings before interest and after taxes (EBIAT) by multiplying EBIT times 1 minus tax rate. For instance, if earnings is $10 and tax rate is 40%, then EBIAT will be: $10 x (1 - 0.40) = $10 x 0.60 = $6. This $6 is your earnings before interest expense and AFTER taxes.
3) Finally to calculate free cash flow, add Depreciation expense to EBIAT less Capital Expenses (CAPEX) and less any investments in Net Working Capital (NWC).
Let's put this summary in to equation format:
i) Operating Income (EBIT) = Annual Revenues - Cash Expenses - Depreciation
ii) EBIAT = EBIT - Income Taxes
iii) FCF (Free Cash Flow) = EBIAT + Depreciation Expense - CAPEX - Increase in Net Working Capital