How To Calculate Cash Flow

Cash flow is net income restated as cash. A business reporting two hundred and forty thousand of net income with sixty thousand of depreciation, a thirty five thousand increase in receivables and a fifteen thousand increase in payables generates two hundred and eighty thousand of operating cash flow, and after ninety thousand of capital expenditure it has one hundred and ninety thousand of free cash flow.

The restatement has two moving parts. Non-cash charges are added back, because depreciation and amortisation reduced net income without any cash leaving. Working capital movements are adjusted, because revenue and expense are recognised when earned or incurred rather than when money moves.

Operating cash flow is the standard measure of whether trading generates money. It sits below net income in the statement of cash flows and is the figure most analysts start from, because it is harder to distort with accounting choices than an earnings number.

Free cash flow subtracts capital expenditure from operating cash flow. Depreciation is added back because it is not cash, but replacing worn out equipment is cash, so capital expenditure has to be deducted somewhere and this is where. A business with strong operating cash flow and heavy capital needs can end up with very little free cash flow.

The working capital adjustments are where the two measures diverge most. Growing businesses tie up cash in receivables and inventory before it is collected, so operating cash flow can be below net income even when the business is healthy and profitable. That gap is a timing effect rather than a profitability problem.

A rising receivables balance reduces operating cash flow, because more of this period's revenue is still outstanding. A rising payables balance increases it, because more of this period's costs have not yet been paid. The two often move together, and the net of the two is what matters.

The sign conventions trip people up more than anything else. An increase in an asset is a use of cash and is subtracted. An increase in a liability is a source of cash and is added. Reversing either convention silently inverts the result.

Cash flow can be strong while profit is negative, which is common for capital-intensive businesses with large depreciation charges. It can also be weak while profit is strong, which is common for fast-growing businesses that finance their own expansion out of working capital.

Cash conversion, operating cash flow divided by net income, is a compact quality check. A ratio near one means earnings are turning into cash; a ratio far above one usually signals heavy depreciation; a ratio below one signals that growth is absorbing cash.

The statement of cash flows also reports investing and financing flows, which are separate sections. Loan proceeds, share issues, dividends and asset sales all live outside operating cash flow, so a large cash movement can appear in a period without touching it at all.

Finally, a single period is noisy. Payables timing, a one-off receivable collection and capital spending cycles all swing the figure, so the trend across several periods is far more informative than any one number.