Reference no: EM132757933

Why in the following question is CF calculated from operating activities as operating profit + depreciation - taxes. Why is it not taking net profit?

1. Net Income and OCF This year, Southern Coat Company had sales of £730,000. Cost of goods sold, administrative and selling expenses, and depreciation expenses were £580,000, £105,000 and £135,000 respectively. In addition, the company had an interest expense of £75,000 and a tax rate of 28 per cent. (Ignore any tax loss carry-back or carry-forward provisions.)

(a) What is Southern Coat Company's net income?

(b) What is its operating cash flow?

(c) Explain your results in (a) and (b).

Answer:

Income Statement
Sales £730,000
COGS 580,000
A&S expenses 105,000
Depreciation 135,000
Operating Profit -£90,000
Interest 75,000
Profit before Tax -£165,000
Tax (28%) 0

a. Net income -£165,000

b. OCF = Operating Profit + Depreciation - Taxes = -£90,000 + 135,000 - 0 = £45,000

c. Net income was negative because of the tax deductibility of depreciation and interest expense. However, the actual cash flow from operations was positive because depreciation is a non-cash expense and interest is a financing expense, not an operating expense.