Healthy businesses normally enjoy substantial cash inflows from their ongoing operations and sales receipts. In simple terms, the related cash inflow will be the adjusted operating profit.
For a growing business, a substantial use of cash will often be an investment for further growth – for example, additional investment in net working capital for expansion. When profitable companies expand too fast, they can run out of cash and liquidity and go bust. (This is known as ‘overtrading’.)
This essential understanding comes up in the workplace when you are asked to:
- calculate operating cash flow
- prepare the statement for the net cash flow from operating activities
- comment appropriately
CALCULATING OPERATING CASH FLOW
A company had the following results and activities for the year just ended.
All amounts are in millions:
| Operating profit: | 50 |
| Tax paid: | 7 |
| Operating profit is stated after charging depreciation and amortisation of: | 2 |
| Additional investment in net working capital: | 39 |
Calculate the net operating cash flow for the year and comment on your findings for the cash manager.
TAX PAYMENTS ABSORB CASH
Our calculation of the net operating cash flow starts with the adjusted operating profit.
Our first adjustment to the operating profit before tax of 50 is to deduct the tax paid of 7. The business must pay the tax authorities promptly. (Or else the tax authority will quickly chase the business.)
Operating cash calculation #1
| Operating profit: | 50 |
| Less tax paid: | (7) |
| After tax | 43 |
DEPRECIATION AND AMORTISATION AREN'T CASH
Operating profit has been stated after charging depreciation and amortisation of #2. But accounting depreciation and amortisation charges are not cash flows. So we need to add back the depreciation and amortisation, as non-cash items within the net operating profit.
Operating cash calculation #2
| Operating profit: | 50 |
| Less tax paid: | (7) |
| Equals after tax | 43 |
| Add back depreciation and amortisation | 2 |
| 45 |
INCREASING WORKING CAPITAL ABSORBS CASH
Our company has made an additional investment in net working capital of 39:
|
Last year's asset / (liability) |
Less | This year's asset / (liability) | = Net working capital (increase) / decrease | |
| Assets (increase) / decrease: | ||||
| Receivables | 116 | 143 | (27) | |
| Inventory | 41 | 64 | (23) | |
| Liabilities increase / (decrease)1: | ||||
| Trade payables | (100) | (111) | 11 | |
| Net working capital | 57 | 96 | (39) |
This is a substantial use of cash. It reduces net cash flow, so it’s an important further deduction in calculating net operating cash flow.
Operating cash calculation #3
| Operating profit: | 50 |
| Less tax paid: | (7) |
| Equals after tax | 43 |
| Add back depreciation and amortisation | 2 |
| 45 | |
| Less: (increase in net working capital) | (39) |
| = Net operating cash flow | 6 |
The cash manager will need to monitor the increase in net working capital. It has absorbed almost all of the positive operating cash flow for the year.
DECREASING WORKING CAPITAL RELEASES CASH
Net working capital is the total of current working assets LESS current working liabilities. Improved working capital management seeks to: (1) reduce current assets; or (2) increase current liabilities; or (3) both.
If either – or both – of these aims is achieved, then the amount of cash tied up in working capital will be correspondingly smaller. This can result in a smaller additional amount of cash being absorbed into working capital, or even a net release of cash from working capital.
CALCULATING NET WORKING CAPITAL CHANGES
Increases in current assets absorb cash. They mean we are tying up more cash by investing in current assets. This includes receivables and inventories.
In contrast, increases in current liabilities RELEASE cash. They mean we are enjoying more credit from suppliers and others. This includes trade payables and non-trade payables. We will still have to pay all our liabilities, of course.
But we can pay them later, rather than now. So, in the meantime, we have more cash in our bank account, and improved operating cash flow.
We need to be careful to get our plus and minus signs the right way around here. It’s a big help to invest time in:
(1) tabulating; and (2) row and column labels with explicit sign conventions.
INVESTING AND FINANCING AREN'T 'OPERATING'
Certain important cash flows aren’t generally considered to be ‘operating’ cash flows. Non-operating cash flows include investing and financing. So don’t include investing or financing items in your calculation of operating cash flows.
Examples of investing and financing items (to exclude from operating cash flow calculations) would be buying or selling tangible fixed assets, and issuing or redeeming bonds.
TRY ANOTHER EXAMPLE YOURSELF
Work through the 10 easy steps in turn to calculate the operating cash flow for the year. You have the following information on Tasman Seas plc.
Figures in 000s
| Current assets | This year | Last year | Current liabilities | This year | Last year |
| Cash and cash equivalents | 1,193 | 1,364 | Trade payables | 102,253 | 91,926 |
| Receivables | 130,938 | 106,991 | Non-trade payables | 35,750 | 17,245 |
| Inventory | 58,634 | 37,205 | Borrowing | 1,250 | 13,750 |
| Total | 190,765 | 145,560 | Total | 139,523 | 122,921 |
Figures in 000s
| Income statement | |
| Revenue | 566,408 |
| Cost of sales | (473,905) |
| Gross profit | 92,503 |
| Depreciation | (1,516) |
| Amortisation | (975) |
| Distribution costs | (6,409) |
| Administration expenses | (37,729) |
| Operating profit | 45,874 |
| Tax paid | (4,800) |
From the information above, calculate the operating cash flow for this year.
Once you've had a go, you can check your answer below.
1. Calculate the after-tax operating profit.
2. Add back depreciation and amortisation.
Changes in current assets:
3. Calculate the increase or decrease in receivables.
4. Deduct the increase in receivables, or add any decrease.
5. Calculate the increase or decrease in inventory.
6. Deduct the increase, or add any decrease.
Changes in current liabilities:
7. Calculate the increase or decrease in trade payables (liabilities).
8. ADD the increase in payables, or deduct any decrease.
9. Calculate the increase or decrease in non-trade payables.
10. ADD the increase, or deduct any decrease.
1 Notice that for changes in liabilities, this adjustment is the opposite way round, compared with the adjustment for changes in assets.
____________________
Author: Doug Williamson
Source: The Treasurer magazine
ANSWERS
Steps 1 and 2
| Operating profit: | 45,874 |
| Less tax paid: | (4,800) |
| Equals after tax | 41,074 |
| Add back depreciation | 1,516 |
| Add back amortisation | 975 |
| Subtotal | 43,565 |
Steps 3 to 10
|
Last year's asset / (liability) |
Less | This year's asset / (liability) | = Net working capital (increase) / decrease | |
| Assets (increase) / decrease: | ||||
| Receivables | 106,991 | 130,938 | (23,947) | |
| Inventory | 37,205 | 58,634 | (21,429) | |
| Liabilities increase / (decrease): | ||||
| Trade payables | (91,926) | (102,523) | 10,597 | |
| Non-trade payables | (17,245) | (35,750) | 18,505 |
| Subtotal from above | 43,565 |
| Less (increase in receivables) | (23,947) |
| Less (increase in inventory) | (21,429) |
| Add increase in trade payables | 10,597 |
| Add increase in non-trade payables | 18,505 |
| Net operating cash inflow | 27,291 |
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