Operating Cash Flow

SOURCE: Corporate Finance Institute. https://corporatefinanceinstitute.com/

What is Operating Cash Flow?

Operating Cash Flow (OCF) is the amount of cash generated by the regular operating activities of a
business in a specific time period. OCF begins with net income (form the bottom of the income
statement), adds back any non-cash items, and adjusts for changes in net working capital to arrive at the
total cash generated or consumed in the period. When performing financial analysis, operating cash
flow should be used in conjunction with net income, free cash flow (FCF), and other metrics to properly
assess a company’s performance.

Operating Cash Flow Example

Below is an example of operating cash flow (OCF) using Amazon’s 2017 annual report. As you can see,
the consolidated statement of cash flows is organized into three distinct sections, with operating
activities at the top, then investing activities, and finally, financing activities. In addition to those three
sections, the statement also shows the starting cash balance, total change for the period, and ending
balance.

Let’s analyze how the operating section works:

• Net income from the bottom of the income statement is used as the starting point

• All non-cash items are “added back” meaning any accruals are reversed, including:

o Depreciation, which an accounting method for expensing property, plant, and

equipment (PP&E) purchases SL Note – this is the most important adjustment for
capital intensive regulated enterprises. For now, we will largely assume away many of
the entries below.

o Stock-based compensation is not paid out with actual cash, but instead with the
issuance of shares

o Other expense/income could include various items such as unrealized gains or losses or
accrued items

o Deferred taxes arise from the difference between accounting methods companies use
when filing their taxes vs their financial statements

• Change in working capital (operating assets and liabilities) adjustments include:

o When inventory on the balance sheet goes up, it results in a reduction of cash

o When accounts receivable increases it also creates a reduction of cash, as it means a

portion of the revenues recorded have not been paid by customers

o When accounts payable, accrued expenses, and unearned revenue increase they cause
an increase in cash
Source: amazon.co

At the bottom of the operating cash flow section, we can see the total, which is labeled as “Net cash
provided by (used in) operating activities.” The line is the sum of all items above it and represents the
total for the period.

Operating Cash Flow Formula

Whether you’re an accountant, a financial analyst, or a private investor it’s important to know how to
calculate how much cash flow was generated in a period. We may take for granted when reading
financial statements how many steps are actually involved in the calculation.

Let’s analyze the operating cash flow formula and each of the various components.
Formula (short form):

Operating Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital

S Labson note: focus on “short form” formula.

Formula (long form):

Operating Cash Flow = Net Income + Depreciation + Stock Based Compensation + Deferred Tax + Other
Non Cash Items – Increase in Accounts Receivable – Increase in Inventory + Increase in Accounts Payable
+ Increase in Accrued Expenses + Increase in Deferred Revenue

The formulas above are meant to give you an idea of how to perform the calculation on your own,
however, they are not entirely exhaustive. There can be additional non-cash items and additional
changes in current assets or current liabilities that are not listed above. The key is to ensure that all
items are accounted for, and this will vary from company to company.

Operating Cash Flow vs Net Income

Net income and earnings per share (EPS) are two of the most frequently referenced financial metrics, so
how are they different than operating cash flow? The main difference comes down to accounting rules
such as the matching principle and accrual principle when preparing financial statements.

Net income includes all sorts of expenses that may have have been paid for and may have just been
created by accountants (such as depreciation).

In addition, a company’s revenue recognition principle and matching of expenses to the timing of
revenues can result in a material difference between OCF and net income.

Unfortunately, it is not possible to simply say that one number is always higher or lower than the other.
Sometimes OCF is higher than net income (as with Amazon, shown above) and sometimes it’s the
opposite.
Source: amazon.com

As you can see in the screenshot above, there is a major difference between the two metrics, and
Amazon has constantly generated more OCF than net income. To be fair though, what OCF doesn’t take
into account is capital expenditures (Capex) or purchases of PP&E. By deducting Capex from OCF you
arrive at Free Cash Flow, which is a more comparable figure.

Operating Cash Flow in Financial Modeling

Calculating the cash flow from operations can be one of the most challenging parts of financial
modeling in Excel. Below is an example of what this activity looks like in a spreadsheet.

As you can see in the screenshot, there are various adjustments to items to reconcile net income to net
cash from operating activities, as well as changes in operating assets and liabilities. In a financial model,
there be separate sections for the depreciation schedule and working capital schedule, which then feed
into the cash flow statement section of the model. The example below is taken from CFI’s Amazon Case
Study Course.
As you can see in this above example, there is a lot of detail required to model the operating activities
section, and many of those line items require their own supporting schedules in the financial model.