(5 of 14) Ch.10 - Operating cash flow (OCF): 3 other ways to calculate - YouTube

It turns out there are three more ways to find the operating cash flow, the bottom-up

approach, the top-down approach and the tax shield approach.

The bottom-up approach says that we start at the bottom and then we go up in only, you

know, subtract-- So we add back depreciation, right, net income plus depreciation.

In the example we just looked at, that would be $7,920 in net income plus $8,000 in depreciation.

This gives us $15,920, the same number we found on the last slide.

How does the top-down approach work?

Essentially, this starts from the very top, from the sales revenue.

And then, we only subtract the expenses which are necessary to calculate the true profit

for the year or the operating cash flow.

So, sales revenue minus cost of produce in-- We don't subtract depreciation, we kind of

skip it and then we jump straight down to taxes and subtract those.

When we do the math, $50,000 in sales revenue minus $30,000 in costs and minus $4,080 in

taxes, that, again, gives us the same result, $15,920.

And the last formula, this is actually formula number four, that could also be used to find

the operating cash flow is called the tax shield approach.

There is no specific order like it's neither bottom-up nor top-down approach.

The formula says look at the difference between the sales revenue and the production cost

multiplied by 1 minus the tax rate.

And then if you add the so-called depreciation tax shield, which is the product of the depreciation

amount and the tax rate.

So, depreciation tax shield means how much of, you know, how much we're saving in taxes

by being allowed to, you know, treat depreciation as an expense, right.

When we are including depreciation as an expense, it lowers all taxable income.

And so, we are able to gain by paying less in taxes.

So, the depreciation tax shield is sort of this extra term that we add to sort of aftertax

income that shows how much of a difference it makes when we are in allowed to treat depreciation

as expense as opposed to the case when we don't, you know, use it as an expense, right.

If you put all numbers in this formula, so open parenthesis, $50,000 minus 30,000, close

parenthesis multiplied by open parenthesis 1 minus 0.34 close parenthesis plus 8,000

times 0.34 gives us $15,920.

So once again, it's exactly the same answer as we got for the top-down approach, for the

bottom-up approach and in the formula, we used on the earlier slides which is how the

operating cash flow is defined in-- on textbook.

So, it doesn't matter which approach you use.

If you have a question, calculate the operating cash flow, you can pick anyone of these four

approaches that you like.

So, question for you, which approach would you use?

What's your favorite approach?

Usually, my students tell me immediately, oh the bottom-up approach and then I asked

them why.

And they always say, well, it's only two numbers.

And then I tell them, you know what, my favorite is the last one, the tax shield approach.

And then they asked me why and I tell them that this is the easiest one.

And then they are all confused.

So, take a look at how the bottom-up approach works.

It's true that there are only two numbers but you're not given the net income.

You need to go through the entire income statement to first find the net income.

And only then, you are working with just two numbers.

Then students will often tell me, OK, fine, I'll use the top-down approach.

It's only three numbers there.

And I tell them, you know what, are you ever given taxes?

No.

You're given a tax rate but not the tax amount.

To find the tax amount, you again need to go through almost every role of an income

statement until you can calculate the taxes.

And then after this kind of discussion, the class sort of agrees with me that the tax

shield approach seems to be the easiest one to use or at least there are no, you know,

preliminary calculations you need to do first because typically the sales revenue is given,

the production costs are given and the depreciation is given.

You don't need to calculate anything first before you use this OCF formula.

But in general, it's completely up to you.

All approaches, all formulas, all four of them give the same numerical answer and you

can use whichever one you like better.