A Top-Down Approach to Computing Operating Cash Flow

Cash flow from investing or financing activities is computed using the direct, top-down approach, but operating cash flow may be computed with either the top-down approach or the indirect, bottom-up approach. The bottom-up approach starts with net income, which is presented in the bottom line of the income statement, and then moves up to adjust any non-cash revenue and expense elements into actual cash flow. The top-down approach, on the other hand, starts with actual cash receipts and cash payments and then reports the total net cash flow.

Operating cash flow is any cash transaction related to a company’s ongoing operations, but it may not be reported as current revenue or a current expense for calculating net income. On the other hand, net income may contain certain cash flow elements, namely revenues received in cash and expenses paid in cash, when they are recognized. Thus, accounting net income can be converted to actual cash flow once adjusted to account for other cash flow transactions such as accounts receivable collection. However, using such an indirect method doesn’t show individual cash flow transactions.

The top-down approach itemizes all cash flow transactions from operating activities and adds them up for the total operating cash flow. Using the top-down approach to compute the operating cash flow, companies list all relevant cash flow transactions, starting with cash receipts on the top and moving down to cash payments. The top-down approach is recommended by bodies that set accounting rules because it facilitates a clearer reporting of a company’s cash flow transactions, showing the cash sources and uses.

Using the top-down approach requires identifying cash flow transactions and keeping a record of all cash receipts and payments from operating activities. Any revenue received in cash in the period when a sale is made often is the top line item used for computing the operating cash flow. Revenue-related cash receipts also include cash collections on outstanding accounts receivable from previous sales. Other cash receipts from operating activities consist of prepayments and deposits from customers for future sales.

Cash payments are reported below the cash receipts. Any expense paid in cash when incurred is reported as the first cash-payment item. Expense-related cash payments also include those used to pay off outstanding accounts payable owed on previous expenses. Other cash payments from operating activities may involve cash used to purchase inventory, pre-cash payments for future expenses or any tax payments.