Operating Cash Flow: Definition & Examples

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  • 0:03 Cost of Running a Business
  • 1:10 Three Approaches
  • 4:49 Barnaby Business Example
  • 6:10 Lesson Summary
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Lesson Transcript
Instructor: Lucinda Stanley

Lucinda has taught business and information technology and has a PhD in Education.

In this lesson we will learn about operating cash flow. We will explore ways that businesses use operating cash flow to manage their business, and see three different approaches to calculating it.

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.

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