Operating Cash Flow

Profit is an opinion about timing. Cash is a fact about the bank account.

Operating cash flow is the bridge between them. Start with profit after tax, add back the charges that reduced profit without anybody paying anything — depreciation above all — and then adjust for the money that moved without touching the profit and loss account, which is the change in working capital. What is left is the cash the operations themselves threw off.

It matters twice in this paper. In Chapter 11 it is the starting point of every discounted cash flow valuation. In the same chapter's start-up metrics it is the sustainability test: positive operating cash flow is what tells you a start-up can eventually fund itself.

Chapter 11's DCF walkthrough builds it explicitly. Projecting OCF means projecting a full P&L — revenue and cost estimates, interest on borrowed capital, depreciation on fixed assets, tax computations — and then converting that profit into cash.

Depreciation and amortisation are added back because they are non-cash items sitting in the P&L. The change in working capital is added or deducted depending on whether net working capital fell or rose during the year: a growing business ties more cash up in stock and receivables, so growth normally reduces operating cash flow even while profit rises.

OCF is then converted into free cash flow. Ongoing capital expenditure and incremental working capital investment — together the reinvestment requirements — are netted out, along with long-term debt repayments, to give the free cash flow that is discounted at WACC.

For an AIF the measure earns its keep at the other end of the deal too. Chapter 12 notes that a pure debt fund's exit is protected by covenants providing for periodic servicing of the debt from the operating cash flow of the company. No operating cash flow, no debt service, and the covenant package is the only thing left.

OCF = PAT + Depreciation ± Non-cash charges in the P&L ± Changes in working capital

Free cash flow = OCF − reinvestment requirements (capex + incremental
                       working capital) − long-term debt repayments

A Category II AIF is underwriting a Rs 90 crore private credit facility to an auto components maker. The projections for year 1:

Now convert to cash. Revenue is growing 22 per cent, and working capital runs at 20 per cent of sales, so net working capital rises by Rs 23 crore:

The company reports Rs 31 crore of profit and generates Rs 42 crore of operating cash, of which Rs 12 crore is actually free. Annual interest on the AIF's new Rs 90 crore facility at 15 per cent is Rs 13.5 crore — more than the free cash flow, and the covenant has to be written against the Rs 42 crore of OCF with a charge over receivables behind it.

Had the same Rs 640 crore of revenue been reached from a smaller base — 40 per cent growth rather than 22 — the working capital drag would be Rs 37 crore, operating cash flow Rs 28 crore, and free cash flow minus Rs 2 crore. Identical revenue, identical profit; only the speed of growth changed.

Chapter 11 (Valuation), section 11.6, Illustration 11.5 Step 1, where OCF is defined and converted into free cash flow for the DCF; and section 11.8.1, where positive operating cash flow is listed as vital for a start-up's long-term sustainability and growth. Chapter 12 uses it again in the debt-fund exit covenants. Expect a computation from PAT, depreciation and a working capital movement.

• Depreciation is added back; it is not ignored. The asset still wears out — that is what the capex deduction below OCF is for.
• Working capital can go either way. The workbook says the change is "either a deduction or an addition depending upon whether the net working capital has increased or decreased". Candidates who always subtract it get the falling-sales case wrong.
• OCF is not free cash flow. Capex and incremental working capital come out afterwards.
• Chapter 11 nets long-term debt repayments out of OCF at Step 1 and then, at Step 4, deducts the outstanding debt again from enterprise value to reach equity value. Reproduce the workbook's table in the exam; be aware that charging the debt claim at both points is not how a textbook firm-level cash flow model is built.
• Positive OCF is not positive profit. A loss-making start-up collecting subscriptions in advance can run positive OCF for years, and a profitable company growing fast can run negative OCF — as the example above shows.
• Interest has already been deducted in arriving at PAT here. Do not add it back and then discount at WACC without knowing which cash flow you are building.