5 Steps to Calculating Indirect Operating Cash Flow

Operating cash flow is a crucial metric that investors and analysts use to evaluate the financial health of a company. It represents the amount of cash generated or consumed by a company’s core operations, excluding investments and financing activities. Direct operating cash flow is relatively straightforward to calculate, but indirect operating cash flow requires a bit more work. In this blog post, we will outline the five steps to calculating indirect operating cash flow.

Step 1: Start with Net Income

The first step in calculating indirect operating cash flow is to start with net income, which is the bottom line of a company’s income statement. Net income represents the total revenue generated by the company minus all the expenses incurred during a particular period. While net income is a useful metric for evaluating a company’s profitability, it doesn’t represent the actual cash flow generated by the company.

Step 2: Adjust for Non-Cash Items

The next step is to adjust net income for non-cash items that are included in the income statement. These non-cash items include items such as depreciation and amortization expenses, stock-based compensation, and deferred taxes. These items are not actual cash expenses, but they do affect net income. To calculate indirect operating cash flow, you need to add back these non-cash expenses to net income.

Step 3: Adjust for Changes in Working Capital

The third step is to adjust net income for changes in working capital. Working capital represents the difference between a company’s current assets (such as cash, accounts receivable, and inventory) and current liabilities (such as accounts payable and accrued expenses). Changes in working capital can have a significant impact on a company’s cash flow. For example, if a company’s accounts receivable increase during a period, it means that the company has not yet collected the cash from its customers, which can negatively impact its cash flow. To calculate indirect operating cash flow, you need to adjust net income for changes in working capital.

Step 4: Adjust for Changes in Other Operating Assets and Liabilities

The fourth step is to adjust net income for changes in other operating assets and liabilities. Other operating assets and liabilities include items such as prepaid expenses, deferred revenue, and other accruals. These items can also impact a company’s cash flow. For example, if a company has a large amount of deferred revenue, it means that it has collected cash from its customers but has not yet recognized the revenue, which can positively impact its cash flow. To calculate indirect operating cash flow, you need to adjust net income for changes in other operating assets and liabilities.

Step 5: Summarize the Adjustments

The final step is to summarize the adjustments made in the previous steps to arrive at indirect operating cash flow. To do this, you need to add back non-cash expenses, adjust for changes in working capital, and adjust for changes in other operating assets and liabilities. The result is the indirect operating cash flow, which represents the amount of cash generated or consumed by a company’s core operations.

In summary, calculating indirect operating cash flow requires a few additional steps beyond calculating direct operating cash flow. By adjusting net income for non-cash items, changes in working capital, and changes in other operating assets and liabilities, you can arrive at a more accurate representation of a company’s cash flow from operations. This metric is essential for investors and analysts to evaluate a company’s financial health and sustainability. By following these five steps, you can calculate indirect operating cash flow and make more informed investment decisions.

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