Operating cash flow formula, with a worked example

The common operating cash flow formula is: net income + non-cash expenses − increase in working capital. Operating cash flow measures cash generated or consumed by regular business operations during a period, and the reported total appears in the operating-activities section of the cash flow statement.

This is the indirect-method formula. It reconciles net income to cash from operations by adjusting for non-cash items and the cash effects of working-capital movements.

Operating cash flow formula: the indirect method

Operating cash flow = Net income + Non-cash expenses ± Working-capital changes

The shorthand “minus increase in working capital” requires account-by-account treatment. Non-cash working capital consists of current assets other than cash, less current liabilities other than debt. An increase in an operating asset reduces cash, while an increase in an operating liability increases it.

Start with net income

Net income is the after-tax profit reported on the income statement and is the starting point for the indirect calculation.

Adjust for non-cash items

Non-cash items are included in the reconciliation because they affect reported net income without necessarily reflecting cash paid or received in the period. Common adjustments include depreciation and amortisation, stock-based compensation, deferred tax, impairment charges, and unrealised gains or losses. The required direction of an adjustment depends on the item.

Apply working-capital signs one account at a time

• Accounts receivable rises: subtract the increase. More recorded revenue remains uncollected.
• Inventory rises: subtract the increase.
• Accounts payable rises: add the increase.
• Accrued expenses rise: add the increase.
• Unearned revenue rises: add the increase.

For a decrease, reverse the sign. A fall in receivables, for example, increases operating cash flow.

Worked example: calculating operating cash flow

Hypothetical inputs for a year:

• Net income: $500,000
• Depreciation and amortisation: $90,000
• Accounts receivable increased: $70,000
• Inventory increased: $40,000
• Accounts payable increased: $25,000

Step 1: Begin with net income.

$500,000

Step 2: Add the non-cash charge.

$500,000 + $90,000 = $590,000

Step 3: Subtract operating-asset increases.

$590,000 − $70,000 − $40,000 = $480,000

Step 4: Add the operating-liability increase.

$480,000 + $25,000 = $505,000 operating cash flow

The result exceeds net income by $5,000. The $90,000 depreciation and amortisation adjustment is partly offset by the $85,000 net cash effect of receivables, inventory and payables.

How the direct method differs

The direct method starts with cash movements rather than net income. In broad form, it is cash received from customers less cash paid to suppliers, employees and other operating obligations. It lists operating cash receipts and payments, while the indirect method provides a reconciliation from net income to cash flow from operating activities.

Where to find the reported number

Look for the cash flow statement and then its operating-activities section, which is normally presented first. The total may be labelled “net cash provided by operating activities” or “net cash used in operating activities.”

Read the lines above the total as well as the headline figure. They identify the non-cash items and working-capital movements that explain the difference between net income and operating cash flow. Operating cash flow can be read alongside net income, free cash flow and other measures rather than as a stand-alone assessment.

Frequently asked questions

How do accounts receivable, inventory and accounts payable affect operating cash flow?

An increase in accounts receivable or inventory reduces operating cash flow. An increase in accounts payable increases operating cash flow. Decreases have the reverse effect.

What is the difference between the direct and indirect operating cash flow methods?

The indirect method begins with net income and adjusts for non-cash items and working-capital changes. The direct method lists operating cash receipts and payments, including receipts from customers and payments to suppliers and employees.

Where is operating cash flow reported on the cash flow statement?

It is reported in the operating-activities section of the cash flow statement, normally the first section. The total may be labelled “net cash provided by operating activities” or “net cash used in operating activities.”

Sources

• Operating Cash Flow - Overview, Example, Formula — corporatefinanceinstitute.com
• Operating Cash Flow: Overview, Formula, And How to Protect It — www.allianz-trade.com