To convert average annual net cash inflow back to average annual operating income, the correct approach is to subtract annual depreciation expense. This is because net cash inflow reflects actual cash received during the year, which does not account for non-cash expenses such as depreciation.
Operating income is determined by subtracting all operating expenses from revenues, and since depreciation is a non-cash expense, it is considered when calculating operating income. By subtracting the annual depreciation expense from the net cash inflow, you adjust the cash figure to reflect a more accurate measure of profitability that acknowledges the expense associated with the wear and tear of tangible assets or the systematic allocation of the cost of an asset over its useful life.
This adjustment is crucial for understanding the true income generated from operating activities, as it aligns the cash flow calculation more closely with accounting principles that recognize the expense regardless of whether it involves an actual cash outflow in that period.