Monday 13 May 2024

Calculating Net Operating Cash Flow number

Calculating Net Operating Cash Flow number 

CASH FLOW STATEMENT
Operating Activities

Net Income before Extraordinaries
+ Depreciation, Depletion & Amortization
+ Other Funds
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Funds from Operations
+/-  Changes in Working Capital
Receivables
Inventories
Accounts Payable
+/- Other Assets/Liabilities
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Net Operating Cash Flow


Main adjustments when calculating the Net Operating Cash Flow number are:

1.  Depreciation and Amortization

This reduced the operating profits in the income statement, but, as it is not a cash flow, it is added back to operating cash flow.

2.  Profit/losses on disposals.  

A profit or loss on the sale (disposal) of an asset compared to the asset's value on the balance sheet (or book value).  The cash received from the sale is included in the investing section of the cash flow statement.   The profit or loss on the sale is included in the operating profit.  The profit or loss (the difference between the cash received and the asset value on the balance sheet) is used to adjust the company's operating cash flow.  A loss is added back to operating profit and a profit is taken away.

3.  Increases/decreases in debtors (sales made on credit).

If a company is growing its sales then often its outstanding debtors will grow as well.   If debtors grow faster than sales, then the company is giving more credit to its customers - not ideal.  If debtors goes down compared to sales then the company is tightening its credit - perhaps by chasing debtors harder.  This affects operating cash flow but does not affect operating profit.

4.  Increases/ decreases in creditors (purchases made on credit_

Companies can make purchases on credit.   This increases their trade creditors balance.  The balance will decrease as payments are made.   An increase in this balance means that the company gets a temporary cash benefit to operating cash flow.  If the balance reduces - if suppliers want paying faster - cash flows out of the company which reduces operating cash flow.

5.  Increases/decreases in stock levels (inventory)

Building up inventory requires cash to be spent.  If more stock is added than is sold, a company's inventory balances will increase and this will show as a cash flow out of the company and reduced operating cash flow.  It will not affect operating profit.  If a company is selling its inventory faster than it is buying raw material, this balance will decrease and the change will be shown as a cash flow added back to operating profit.  Operating with inventory levels that are too low can generate expensive problems, example, when there is a sudden dramatic increase in demand.   In general, expect inventory levels to go up and down with sales levels.

6.  Amount paid into a final salary pension fund is more/less than pension cost expensed in the income statement.  

In recent years, final salary pension schemes have become problematic for some companies as the money in the pension fund has not been enough to pay the promised pensions in the future.  This has meant that cash top up payments in excess of the regular expense have been required.  This is shown by a reduction in a company's operating cash flow and is a deduction from the starting operating profit figure.   



Changes in working capital (Receivables, Inventories and Accounts Payable)

Working capital refers to the amount of cash a company needs to undertake its day-to-day activities.  

If working capital is increasing, then this shows the amount of cash a company might need to borrow - from a bank overdraft facility - to finance its day-to-day activities as it waits for cash to flow in.   The smaller a company's working capital requirement, the better its cash flow and financial position tends to be.



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