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(4 of 14) Ch.10 - Operating cash flow (OCF): explanation & example - YouTube
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Let's start with the operating cash flow.
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The idea is it's nothing but annual profit
from sales.
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So, there is operating cash flow for year
one, for year two, for year three and so on
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with the last operating cash flow that needs
to be calculated with for the final year of
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the investment project.
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However, operating cash flow is not the same
thing as net income.
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So, what exactly is it?
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How do we calculate profit for each year?
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If you go back to, you know, accounting, right,
how would accountants do it?
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They would look-- They would basically build
you an income statement, one income statement
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for each year, for year one, for year two
and so on.
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What does the standard income statement look
like?
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The first rule is the sales revenue, the money
that would be coming in from selling our product.
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And then everything that follows in the row鈥檚
underneath is different expenses.
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First, we subtract the cost of goods sold
then we subtract the depreciation.
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After subtracting these two items from the
sales revenue, we get EBIT, which stands for
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earnings before interest and taxes.
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Then we subtract interest expenses on loans
which gives us taxable income or earnings
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before taxes, EBT.
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Then we multiply that by a certain corporate
income tax rate that, you know, is applicable
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to this company.
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And I have to subtract in taxes.
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We are left with net income.
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So, this is how accountants calculate profit
for every year.
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However, the-- a couple of things that we
finance people are doing different thing.
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First, remember from the early slide, interest
expenses on loans are considered irrelevant
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for capital budget and decisions, right?
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We are not going to use interest expenses
in our net present value calculations, right?
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The second thing that we are going to be careful
about is net income.
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Is this really how much profit we make?
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Well, not exactly.
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It's actually understated.
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There's one item in this list of expenses
that is not a true expense.
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It's a so-called non-cash item.
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And that's depreciation.
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Depreciation is not an actual cash expense.
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It's only there because of how we would need--
how we need to be calculating taxes correctly.
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It's only there for tax purposes.
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And so, because depreciation is something
we never spend, we need to add it back to
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correctly calculate the profit for the year.
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And this is how you can find the operating
cash flow.
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So, you can take net income the last role
of a standard income statement and add the
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depreciation amount back to it.
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The textbook's definition of the operating
cash flow is EBIT, earnings before interest
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in taxes, plus the depreciation minus taxes.
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So, by adding depreciation back to EBIT, we
are essentially saying that we just have sales
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revenue minus cost of good sold.
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And then, the only thing that we subtract,
the only other thing that we subtract is taxes.
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We are not subtracting interest expenses.
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Let's look at the following example.
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Let's say we are considering a new investment
project, right.
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And we are now interested in calculating the
operating cash flow for the first year of
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this project.
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Here's what we know about the first year.
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Over one year, a firm's sales revenue is expected
to equal $50,000.
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Production cost would equal $30,000, depreciation
expense for tax purpose will equal $8,000
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and corporate income tax rate is going to
be 34%.
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How would you calculate the operating cash
flow?
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Well, let's build the entire income statement
first.
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And then, you'll just pick in items that we
need to follow the formula from the previous
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slide to find the OCF.
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The income statement would need to start with
the $50,000 in sales revenue.
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Then we subtract production costs minus $30,000.
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Then we subtract depreciation minus $8,000
which gives us the earnings before interest
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in taxes.
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That's $12,000, right?
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Twelve thousand dollars is 50,000 minus 30,000
minus 8,000.
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Then we need to subtract the tax amount.
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We are given a 34% corporate income tax rate.
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If we multiply 34% by the taxable income,
which is the EBIT of $12,000, we would get
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$4,080.
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After subtracting $4,080 in taxes from the
taxable income of $12,000, we get the net
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income equal to $7,920.
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Now, how do we find the operating cash flow?
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Following the formula from the previous slide,
we take EBIT which is $12,000.
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We added depreciation back so plus $8,000.
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And then, we subtract taxes, minus $4,080.
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This gives us $15,920.
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This is the profit, the true profit that we
would be earning over the first year of this
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investment opportunity.
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