Reading: The Cash Flow Statement

The Operating Cash Flow tells us how much cash a firm generates with its operations. 

This secion shows how we can derive the operating cash flow using the information from the firm's balance sheets and income statements.

From before, we know that NOPLAT reflects the firm's net income which is attributable to its operating activities. Therefore, NOPLAT is a good starting point to determine the operating cash flow. The problem with NOPLAT is, however, that it reflects accounting earnings and that accounting earnings do not necessarily correspond to real cash flows.

To get from NOPLAT to the operating cash flow, we therefore typically have to make three adjustments: 

1. Add-back Depreciation and amortization charges 
2. subtract increases in the Operating assets
3. add increases in the Operating liabilities.

 

Here is why:

• We add-back depreciation and amortization charges because they do not reflect a direct cash flow. Depreciation is an accounting charge which transfers a portion of a fixed asset's book value from the balance sheet to the income statement during each year of the asset's life. Similarly, amortization is an accounting charge which transfers a portion of an intangible asset's book value form the balance sheet to the income statement. While these accounting charges reduce the firm's accounting income, they are not directly cash relevant. Because of these accounting charges, the firm's NOPLAT understates the actual operating cash flow. We can correct this bias by adding back the depreciation and amortization charges to NOPLAT.

• Similarly, not all sales and operating expenses the company incurs are cash relevant, and not all the cash it collects and spends with its operating activities shows up in the income statement. Here are some examples:
• A firm that sells goods and services on account records an earning (sales increase) but does not directly collect any cash. Instead, the financial claim against the customer is added to the firm's accounts receivable. An increase in accounts receivable therefore indicates that the Net revenues in the income statement overstate the actual operating cash flow from selling goods and services. We can correct the bias by subtracting such an increase in accounts receivable from NOPLAT.
• In contrast, a customer who pays a bill clearly generates a cash flow for the company, but this cash flow does not show up in the income statement. It reflects a collection of an account receivable and therefore simply constitutes an asset swap. A decrease in accounts receivable therefore indicates that the net revenues in the income statement understate the actual operating cash flow from selling goods and services. We can correct the bias by adding such a decrease in accounts receivable to NOPLAT.
• Similarly, a company that buys material on account records expenses but does not pay cash. Instead, its operating liabilities increase. An increase in accounts payable therefore indicates that NOPLAT understates the operating cash flow, which is why we add increases in operating liabilities to get from NOPLAT to operating cash flows.
• Later, when the company pays the bill, cash flows out and accounts payable decrease by the same amount. As in the case of the accounts receivable, this transaction bypasses the income statement. Therefore, to get from NOPLAT to operating cash flow, we subtract decreases in operating liabilities.
• Similar arguments can be made for all other operating assets (f. ex., inventory) and operating liabilities (f. ex., deferred tax liabilities).

 

Let's apply these considerations to our firm X. For completeness, here are the (simplified) balance sheets and income statement that we have derived in the previous section:

 

 

Also, remember that we have derived a NOPLAT of 3'200 for Year 1.

 

Here are the relevant steps that bring us from NOPLAT to the operating cash flows:

• As we see in the income statement, firm X records Depreciation and amortization charges of 3'000. Because these charges are no direct cash flow, we add them back to the NOPLAT.

• The balance sheet ndicates that the Operating assets increase by 300 (from 5'000 to 5'300). Based on the rules defined above, we subtract this increase from NOPLAT because it reflects earnings which have not yet been converted into cash. (Think of it as additional capital that is tied-up in the firm's working capital.)

• Finally, the balance sheet indicates that Operating liabilities have increas by 600 (from 2'300 to 2'900). We add such an increase to NOPLAT because it reflects expenses which the company has not yet paid. (Think of it as additional "financing" that the firm receives from its trade partners.)

With these adjustments, we can derive the firm's Operating cash flow. The following table shows the result:

 

 

Interpretation: With its operating activities, the firm generates a cash flow of 6'500 in Year 1. Because of the substantial depreciation and amortization charges, this operating cash flow is considerably higher than the NOPLAT of 3'200.

The operating cash flow is an important indicator of the financial health of the firm's business, as it tells us whether the firm is able to earn more cash than it spends during a specific period. No business can prevail in the long run if its operating activities burn more money than they generate.

However, the operating cash flow does not yet provide a full picture of the firm's ability to generate cash. To get that picture, we have to also incorporate the two other dimensions of its activities: Investments and financing. This is what we do next.