CF 7-1A – Calculating Operating Cash Flow – Corporate Finance

Let's have a run through problem 7-1a. We're going to use accounting information to compute cash flows, specifically operating cash flows. The skill we learn in this video will be used all through this chapter, so it's a very important video. Let's jump into it. Consider a potential project with the following information, sales, costs, depreciation, and a tax rate. We're asked first to prepare an income statement, and then, this is the key one, to use that income statement to compute operating cash flow. Let's prepare an income statement with the information we have. We're given the sales, so that's generally the starting point of most income statements. Something kind of fake in this question is it gives costs, where a typical income statement will have those costs broken out, cost of goods sold, selling and administrative expenses. These types of things will be broken out separately. This one lumps them all together as costs, $120,000. Sales minus cost of goods sold would be gross profit. Sales minus our costs is our income before other expenses like depreciation and interest and taxes. In finance, we call that EBITDA EBITDA. What comes after that? Depreciation. Let's take out our depreciation, $30,000, and that leaves us with EBIT of $50,000. In this chapter, we are going to exclude interest from most of our analyses. The reason we exclude interest is we're thinking about the cash flows of some future project that our company is getting into, and we don't want to consider interest. The reason is because we want to consider the project on its own merits. If we're taking interest out, that's not the project's fault we had to borrow. You just want to figure out what's going on with the project. You can worry about the interest later in future calculations, but just looking at the project, analyzing a project, don't consider interest. That's a rule of thumb. It's not a hard and fast rule. Some companies will consider interest, but in our class, we're going to ignore the effects of interest. EBIT is $50,000. We're going to ignore interest, so then we just deal with taxes because we're not going to have any interest. Taxes are 20%, $50,000 minus 20%, well, 20% of 50 is $10,000. Our net income, our profit here, is going to be $40,000. Now, profits are not cash flows, but we've solved part, right? This is the answer for A. Cash flows, though, are calculated a little differently, so I've got a little formula down here for part B. Let me drag it up. Here's how we're going to calculate our cash flows. In this formula, we're going to use throughout the chapter, so it's one worth either memorizing or if you get a formula sheet, putting it on that formula sheet. Operating cash flow equals EBIT plus depreciation minus taxes. We just look at this income statement. We go, what involves cash or what doesn't involve cash? The key thing that doesn't involve cash is depreciation, so we want to exclude it from our calculation. We start here with the EBIT. We say, wait, we shouldn't have taken out depreciation, so we add it back, but we do need to take out taxes because they do involve cash and those are part of operating cash flows, so we'll take that out. That's the formula. Start with EBIT. You take out your depreciation. You add back. Rather, you add back your depreciation. You take out your taxes. Let's do that. $50,000, add back depreciation plus $30,000, take out taxes minus $10,000. You may look at this and go, I could do this several other ways, and there are several other ways you could find your way to a correct answer. This is the standard way to do it, though, and as things get more complicated, this is the better way to do it. You might think, I've got a shortcut to do this, and you could come up with a shortcut and get the right answer. I would advise you just to do it this way, and it'll serve you well. $50,000 plus $30,000 minus $10,000 is, let me do the math, $70,000, so that is our operating cash flow. That would go into calculations, when you're saying, the value of the project is the present value of future cash flows. In previous questions, we just gave you the cash flow. From now on, you're going to have to come up with it, and that's how you would come up with it. Other questions will require you to use something called the depreciation tax shield to come up with the operating cash flow. That's what this is training us to do. The first thing is, what's the depreciation tax shield? It's how many dollars' worth of taxes are saved because we have depreciation. Remember, depreciation is non-cash, so there's no negative $30,000 in cash flow as a result of depreciation. In fact, it reduces our taxable income, and it reduces our tax bill, so depreciation saves us money. It's kind of counterintuitive. Depreciation is going to save us a $30,000 expense on the income statement, but it saves us $6,000 in cash because it saves us $30,000, it reduces our taxable income. We pay 20% tax, so 30,000 times 20% is $6,000. That's our tax savings as a result of depreciation. Let me show you in the formula. I feel like I got a little bit over my skis there, but I think this will make it pretty clear. Our tax shield is just the depreciation times the tax rate, in this case, 30,000 times 20%, which is $6,000. That's how much tax savings there are because I get to deduct depreciation, and again, depreciation is non-cash, so it's actually cash savings. It's a little counterintuitive, right? It's an expense, but it actually saves you cash. A little bit weird to wrap your head around. Okay, part D says, using the depreciation tax shield, the thing we just calculated, recalculate operating cash flow. We call this the tax shield approach to calculating cash flow. We already calculated it, $70,000. We're going to do it a different way. The reason we want to learn to do it a different way, simple. Some of the questions, we're not going to have enough information to do it the straightforward way, the standard way. We'll have to work backwards. Here's how you do it. Here's the formula. Sales minus cost, so 200,000 minus our cost, which again, are like cost of goods sold, selling and admin expenses, research and development, these types of costs. So 200 minus 120, $80,000, times one minus the tax rate, times 75, no, 80%, one minus 20%, so it's times 80%. Let's just do the math here, $80,000 times 80%, $64,000. Okay, so again, we've calculated the number. What kind of, does it mean? Basically it's saying, well, let's take our sales minus our cash expenses and say, what if that was what I got taxed on? How much money would I walk away with? Just basically like a cash income statement, cash items only. So if I looked at my cash items only, I would end up walking away with 64 grand. I would have made $80,000 and then I would be taxed $16,000, so I would walk away with $64,000. However, because depreciation is a thing, if I'm looking at this cash only, I ignore depreciation, but depreciation saves me money. How much does depreciation save us? $6,000, the amount of the tax shield we just calculated. So it's 64 plus we save six grand because of depreciation. So we walk away with $70,000 as our operating cashflow. Same answer as we got up there. Again, we're calculating the same thing two different ways. You don't generally have to do that. You just calculate it one way and you use that number in your calculations, but there will be problems where we just use B, the most straightforward standard way of doing this, and there will be problems where we don't have enough information and so we have to use the formula in D and therefore we have to come up with our tax shield. So there we go. 718 sort of sets the table for a lot of future calculations this chapter. As always, thank you so much for watching and if you made it to the end, I hope you'll give me a like. Have a great day. Bye for now.