Operating cash flow is the cash a business generated from its day-to-day operations during a period, reported as the operating activities subtotal of the statement of cash flows. The operating cash flow formula comes in two forms, and they are not alternatives that produce different answers. The indirect method starts at net income and adjusts it back to cash. The direct method adds up the cash actually received and the cash actually paid. Both report the same subtotal, so the difference between them is presentation, not answer.
The Subtotal Both Formulas Are Building
Neither form invents a figure. A statement of cash flows for a period shall report net cash provided or used by operating, investing, and financing activities and the net effect of those flows on the total of cash, cash and cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents during the period (FASB Accounting Standards Update 2016-18, ASC 230-10-45-24).
Operating is the residual of those three sections, the one that catches what is not investing or financing. Under Topic 230, cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income (FASB Accounting Standards Update 2016-15, Basis for Conclusions).
So this figure is a subtotal that a required statement produces under an accounting standard, which is the opposite of free cash flow, a measure built afterwards by subtracting capital expenditures from it and defined by no standard at all.
The Operating Cash Flow Formula, Indirect Method
operating cash flow = net income
+ non-cash charges such as depreciation and amortization
-/+ gains and losses whose cash effects are investing or financing
+/- the change in operating working capitalNet income is the bottom line of the income statement, the accrual result for the period. Non-cash charges are amounts that reduced that result without cash leaving, depreciation and amortization being the usual pair, so they go back on. Gains and losses whose cash effects belong in investing or financing come out as well, a gain subtracted and a loss added back, because the cash they relate to is reported in one of those other two sections rather than this one. Operating working capital is the set of balances that sit between an entry and its cash. An increase in accounts receivable is revenue recorded but not yet collected, so it comes off, and an increase in accounts payable is cost recorded but not yet paid, so it goes on.
The standard puts the same instruction in stricter words. Entities that choose not to provide information about major classes of operating cash receipts and payments by the direct method shall determine and report the same amount for net cash flow from operating activities indirectly, by adjusting net income to reconcile it to net cash flow from operating activities (FASB Accounting Standards Update 2016-14, ASC 230-10-45-28).
Two things come out, not one. The adjustment removes the effects of all deferrals of past operating cash receipts and payments, such as changes during the period in inventory and deferred income, and all accruals of expected future operating cash receipts and payments, such as changes during the period in receivables and payables. It also removes every item included in net income that does not affect operating cash, such as depreciation of property, plant, and equipment and amortization of finite-life intangible assets (FASB Accounting Standards Update 2016-14, ASC 230-10-45-28).
That second removal reaches every item whose cash effects are related to investing or financing cash flows, such as gains or losses on sales of property, plant, and equipment and discontinued operations, and gains or losses on extinguishment of debt (FASB Accounting Standards Update 2016-14, ASC 230-10-45-28). A gain on the sale of equipment is neither a non-cash charge nor a working capital movement, and leaving it inside the operating subtotal is the error the paragraph is written to prevent.
The Direct Method
operating cash flow = cash collected from customers
+ interest and dividends received
- cash paid to employees and suppliers
- interest paid
- income taxes paid
+/- other operating receipts and paymentsIn reporting cash flows from operating activities, entities are encouraged to report major classes of gross cash receipts and gross cash payments and their arithmetic sum, the net cash flow from operating activities, and that is the direct method (FASB Accounting Standards Update 2016-15, ASC 230-10-45-25).
An entity using the direct method separately reports seven classes at a minimum, five of them named and two of them catch-alls (FASB Accounting Standards Update 2016-15, ASC 230-10-45-25). Cash collected from customers, including lessees and licensees, is the first receipt class. Interest and dividends received is the second receipt class, and interest and dividends that are donor restricted for long-term purposes are not part of it. Other operating cash receipts, if any, carries whatever is left on that side. Cash paid to employees and other suppliers of goods or services, including suppliers of insurance and advertising, is the operating cost line. Interest paid is reported apart from it. Income taxes paid is reported apart again. Other operating cash payments, if any, closes the list.
Both Formulas, One Answer
The wording settles it. An entity choosing the indirect route shall determine and report the same amount for net cash flow from operating activities (FASB Accounting Standards Update 2016-14, ASC 230-10-45-28), so a gap between the two answers is an error in one of them, never a difference of method.
It is not optional for a business entity either. The reconciliation of net income to net cash flow from operating activities described in paragraph 230-10-45-28 shall be provided regardless of whether the direct or indirect method is used, and only a not-for-profit entity presenting the direct method is relieved of it (FASB Accounting Standards Update 2016-14, ASC 230-10-45-29). A business entity that presents the direct method still prepares the indirect computation.
The standard illustrates the pair on one company. A manufacturing entity’s statement of cash flows for a year is shown using the direct method at paragraph 230-10-55-10, and the same entity’s statement for the same year prepared using the indirect method is shown at paragraph 230-10-55-13 (FASB Accounting Standards Update 2016-18).
A Worked Example
Say a firm closes a year on the amounts below, with the whole tax charge paid in cash during the year and no investing or financing activity in the period. Amounts subtracted are shown in parentheses.
Revenue 500,000
Operating costs (360,000)
Depreciation (25,000)
Income before income tax expense 115,000
Income tax expense (20,000)
Net income 95,000
Accounts receivable increased by 30,000
Accounts payable increased by 12,000
Indirect method
Net income 95,000
Depreciation 25,000
Increase in accounts receivable (30,000)
Increase in accounts payable 12,000
Operating cash flow 102,000
Direct method
Cash collected from customers 470,000
Cash paid to employees and suppliers (348,000)
Income taxes paid (20,000)
Operating cash flow 102,000The two columns are built from different lines and land on the same subtotal. Collections are revenue less the growth in receivables, and cash paid to employees and suppliers is operating costs less the growth in payables. Depreciation never appears in the direct column because no cash moved for it, which is the same reason the indirect column has to add it back.
What Operating Cash Flow Is Confused With
Net Income
Net income is the accrual result, and this subtotal is what remains once the items inside it that did not move operating cash are taken out, which is why the indirect method begins at one and finishes at the other. A period can close with positive net income and less cash than it started with, and the reconciliation is where that gap becomes visible line by line.
Operating Income
Operating income is an accrual subtotal of the income statement, struck before interest and income tax. Operating cash flow is cash that actually moved, and it lands after the income taxes actually paid. Accrual subtotal against cash moved is the whole separation.
EBITDA
EBITDA rebuilds a figure upward from net income by adding back interest, tax, depreciation and amortization, and it stops there. The indirect method makes two of those same add-backs and then keeps going into receivables, payables and inventory, so the two figures part company whenever working capital moves. EBITDA is also a non-GAAP measure, while this subtotal is required on the face of a statement prepared under the standard.
Free Cash Flow and a Forward Forecast
Free cash flow starts from this subtotal and subtracts capital expenditures, which is worked through in the formula for FCF. A rolling weekly cash flow forecast is not a version of either, because it projects receipts and payments that have not happened yet rather than reporting a period the books have closed on.
A Cash-Basis Restatement
Adjusting net income to operating cash flow inside a set of accrual statements is not the same job as restating a client onto the cash method for its return, which can require the Commissioner’s consent and is covered in the accrual to cash adjustment.
Where a CPA Firm Meets the Number
A firm builds this subtotal at close, out of account movements it has already proved. Every working capital line in the reconciliation has to tie to the change in that account, and any part of the movement that came from something other than operations has to be taken out before it does, because a receivable acquired with a business is not a collection the period failed to make.
Classification is the other exposure. An item dropped into the investing or financing section moves the operating subtotal without a dollar of cash moving, and the restatement record behind that risk is set out in the formula for FCF.
Common Questions
There are two, and the standard treats them as one answer reached two ways. Start at net income, add back the non-cash charges, then apply the working capital movements. Or add up cash collected and subtract cash paid, in the classes the standard sets. The second is the presentation the standard encourages, and the first is what it requires of entities that choose not to present the classes (FASB Accounting Standards Update 2016-15, ASC 230-10-45-25).
No accounting standard defines the operating cash flow ratio or sets a level for it, so any figure quoted as good is the view of whoever quoted it rather than a rule, and whatever sits in the denominator has to be stated before the answer means anything. What the subtotal supports without a benchmark is a comparison against the same business’s own prior periods and against the obligations actually falling due in the next one.
No. EBIT is an accrual earnings figure struck before interest and income tax, and it does not have to equal operating income either. Operating cash flow measures cash that moved, income taxes paid included. Uncollected revenue, unpaid costs, or a non-cash charge in the period is enough to pull them apart.
It says the period’s operations turned into cash, and no more than that. A collection push or a stretch on supplier payments raises the figure for one period without changing what the business earns, and both land in the working capital lines rather than in net income, so the reconciliation is worth reading before the subtotal.
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