Being able to assess a company's operating cash flow (OCF)—and how that is impacted by taxes—is an important skill in evaluating a company's overall health.
The operating cash flow is vital when considering whether the company can generate enough positive funds to maintain and grow its operations. If not, the company may require external financing.
Shorter turnover rates in inventory and shorter times for receiving funds increase a business's operational cash flow. Items such as depreciation and taxes are included to adjust the net income, rendering a more accurate financial picture. Higher taxes and lower depreciation methods adversely impact the operational cash flow.
Key Takeaways
- Operating cash flow reveals the cash that a company generates through its business operations.
- This is an important indicator for gauging how well a company can continue its operations and grow.
- Calculating taxes in operating cash flow involves reverse-engineering the following equation: Operating Cash Flow = EBIT + Depreciation - Taxes where EBIT refers to earnings before interest and taxes.
Understanding Operating Cash Flow
Operating cash flow is a metric used in financial analysis representing the cash generated or used by a company's core business operations. It provides insights into a company's ability to generate cash from its day-to-day activities, excluding financing and investing activities. By focusing solely on cash generated from operations, OCF offers a clearer picture of a company's liquidity, financial health, and ability to sustain its operations over the long term.
Investors, lenders, and analysts use OCF as it tells part of the story of a company's health. A positive OCF indicates that the company is generating sufficient cash from its core operations to cover operating expenses. Conversely, a negative OCF suggests that the company may be experiencing cash flow issues. By understanding and monitoring OCF, stakeholders can better informed decisions based on cash implications of a company.
Components of Operating Cash Flow
Before we look more specifically at taxes, let's take some time to look at operating cash flow at a high level. The calculation of OCF starts with net income, which is the profit a company earns after all expenses, taxes, and interest have been deducted from total revenue. Unlike net income, which is calculated on an accrual basis, OCF adjusts for non-cash items and changes in working capital to provide a clearer picture of cash availability.
One key component of OCF is adjustments for non-cash items. These are expenses or revenues reported on the income statement that do not involve actual cash transactions. Common examples include depreciation and amortization which account for the wear and tear of tangible and intangible assets, respectively. Although these expenses reduce net income, they do not impact cash flow since no cash is spent. By adding back depreciation and amortization to net income, OCF adjusts to remove the effect of these non-cash charges.
Changes in working capital are another essential component in calculating OCF. Working capital refers to the difference between current assets and current liabilities, representing the short-term financial health of a company. Adjustments to OCF include changes in accounts receivable, inventory, and accounts payable. For example, an increase in accounts receivable indicates that more sales were made on credit, reducing cash flow. Conversely, an increase in accounts payable suggests that the company is delaying payments to suppliers, which temporarily boosts cash flow.
How to Calculate Taxes in Operating Cash Flow
The operating cash flow indicates the cash a company brings in from ongoing, regular business activities. It can be found on a company's annual or quarterly cash flow statement. Simply, it is Total Revenue - Operating Expenses = Operating Cash Flow.
Taxes are included in the calculations for the operating cash flow. Cash flow from operating activities is calculated by adding depreciation to the earnings before income and taxes and then subtracting the taxes.
A company's EBIT—also known as its earnings before interest and taxes—consists of its net income before income tax and interest expenses are deducted. Once a company's EBIT is known, multiply that by the tax rate to calculate the total tax paid. Finally, to calculate operating cash flow, use the following equation: EBIT - tax paid + depreciation.
In terms of how to calculate OCF with the tax rate already known, the equation above can be simply reverse-engineered, solving for the unknown variables.
Impact of Taxes on Cash Flow
Proper tax planning is important since it can impact a company’s cash position. Companies can assess their overall tax situation, considering income tax, indirect tax, and tax benefits.
Tax policies can also impact how businesses depreciate capital assets. In this way, faster depreciation can theoretically reduce the user cost of capital and increase the cash flows of companies.
OCF and Deferred Tax Assets
Deferred tax assets represent potential tax benefits that can reduce future tax liabilities and increase cash flow. For example, if a company has net operating losses or unused tax credits, it may be able to offset future taxable income, resulting in lower tax payments and higher cash flow. On the flip side, deferred tax liabilities represent future tax obligations that will require cash outflows, reducing cash flow in the future.
Deferred tax assets and liabilities are recorded on the balance sheet and adjusted periodically to reflect changes in tax laws, rates, and expectations about future profitability. When calculating OCF, adjustments are made to account for changes in deferred tax assets and liabilities. For example, Increases in deferred tax assets are added back to net income, as they represent future tax benefits that will enhance cash flow. Meanwhile, increases in deferred tax liabilities are deducted from net income, as they represent future tax obligations that will reduce cash flow.
Importance of OCF After Taxes
Investors find it important to look at the cash flow after taxes (CFAT), which indicates a corporation's ability to pay dividends. The higher the cash flow, the better the company is financially, and the better positioned it is to make distributions. Income the company has from outside of its operations is not included in the operating cash flow. Any dividends paid and infrequent long-term expenses are often excluded from this calculation as well.
One-time asset sales are also noted, as they inflate the cash flow numbers during the relevant time period. Investors look at the balance and income statements to gain a better knowledge of the overall health of a company.
OCF and Tax Planning
Companies may leverage OCF to better plan for tax implications in an attempt to reduce what it may owe in the future. One key strategy is to defer taxable income and accelerate deductible expenses whenever possible. By delaying the recognition of income until future periods and accelerating expenses into the current period, businesses can potentially reduce current tax liabilities.
Another strategy is that businesses may choose to defer the receipt of income or delay the sale of assets until tax rates are lower, thereby reducing their tax obligations and preserving cash flow. Such strategies like this may only be possible if a company best understands not only its current operating cash flow but it's future or forecasted operating cash flow. This ensures that the company does not risk operations in favor of potential tax savings.
Does Operating Cash Flow Include Taxes?
Yes, operating cash flow includes taxes along with interest, given that they are part of a business's operating activities.
Is Operating Cash Flow the Same As EBIT?
Operating cash flow is different from earnings before interest and tax (EBIT), but both are metrics used to assess a company's financial health. Operating cash flow is the cash generated from a company's core business activities. By contrast, EBIT shows a company's profitability by looking at its net income before expenses, interest, and tax have been deducted. EBIT is also used to analyze the performance of a company's core business.
What Is the Formula for Calculating Taxes in Operating Cash Flow?
Calculating taxes in operating cash flow requires reverse-engineering the following formula: Operating Cash Flow = EBIT - tax paid + depreciation. You would then solve for unknown variables, assuming the tax rate is known.
The Bottom Line
A company's operating cash flow can be significantly impacted by higher taxes and lower depreciation methods. In this way, it can be important to calculate the taxes in operating cash flow to get a clearer picture of how they impact a company's overall financial situation and its ability to pay dividends.
