Operating cash flow (OCF) is the cash generated by a company’s normal business operations. It helps determine whether a company generates enough positive cash flow to sustain and grow its operations without external financing. A company’s cash flow statement includes three types of cash flows: operating, investing, and financing.
Operating cash flow measures the inflows and outflows related to a company’s main business activities, such as selling and buying inventory, providing services, and paying wages. Any investment and financial transactions such as loans, purchase of capital equipment and dividend payments are excluded.
Key points:
Operating cash flow is the first part of the cash flow statement that shows cash from investing and financing activities.
Operating cash flow is calculated using the indirect or direct method.
The indirect method starts with net income on the income statement and then adds non-cash items to arrive at the cash basis value.
The direct method tracks all transactions for the period on a cash basis and uses actual cash inflows and outflows in the statement of cash flows.
Accounting for Operating Cash Flows (OCF)
Operating cash flow represents the cash impact of a company’s net income (NI) from its primary business activities. Operating cash flow – also referred to as cash flow from operating activities – is the first part of the statement of cash flows.
Operating cash flow provides a clear picture of the reality of business operations. For example, a large sale increases revenue, but if the company has difficulty collecting cash, the sale is not a real benefit to the company. On the other hand, a company may generate high amounts of operating cash flow but report low net income if it has many fixed assets and uses accelerated depreciation calculations.
A company that is not bringing in enough cash from core business operations may need to find temporary external funding through financing or investments. However, this is unsustainable in the long term. Operating cash flow helps assess the financial stability of a company’s operations. A portion of operating cash flows may be presented under generally accepted accounting principles (GAAP) using the indirect or direct method. If the direct method is used, the company must still make a separate reconciliation to the indirect methods.
The operating cash flow ratio represents a company’s ability to repay its debts with existing cash flows. It is determined by dividing operating cash flows by short-term liabilities. A ratio greater than 1.0 means that the company is in a strong position to repay its debts without incurring additional liabilities.
Indirect method
Using the indirect method, net income is adjusted to a cash basis using changes in non-cash accounts such as depreciation, receivables (AR), and accounts payable (AP). Since most companies report net income on an accrual basis, it includes various non-cash items.
OCF = NI + D&A – NWC
Where:
NI equals the company’s net income
D&A is depreciation and amortization
NWC is the increase in net working capital
Net income must be adjusted for changes in the working capital accounts on the company’s balance sheet. For example, an increase in AR indicates that revenue has been earned and reported in net income on an accrual basis, although no money has been received. This increase in AR must be subtracted from net income to determine the true monetary impact of the transactions.
Conversely, an increase in AP indicates that costs have been incurred and booked on an accrual basis that have not yet been paid. This increase in AP would need to be added back to net income to determine the true impact on cash.
An example of the indirect method
Consider a manufacturing company that reports net income of $100 million while its operating cash flow is $150 million. The difference results from $150 million in depreciation expense, a $50 million increase in accounts receivable, and a $50 million decrease in accounts payable. In the operating cash flow section of the cash flow statement, it would appear as follows:
Net income $100 million
Depreciation Add back $150 million
AR Increase Less than $50 million
AP Reduction Less $50 million
Operating cash flow of $150 million
Direct method
The second option is the direct method, where the company records all transactions on a cash basis and displays the information using actual cash inflows and outflows during the accounting period. Examples of items included in the direct method presentation of operating cash flows include:
Salaries paid to employees
Cash paid to vendors and suppliers
Money collected from customers
Interest income and dividends received
Income tax paid and interest paid
This method is simpler than the indirect method with fewer factors to consider. However, it only accounts for monetary income and expenditure. It is calculated according to the formula:
OCF = Cash Revenue — Operating expenses paid in cash
Operating cash flow vs. free cash flow
Operating cash flow is different from free cash flow (FCF), which is the cash a company generates after accounting for operations and other cash flows. Both metrics are commonly used to assess a firm’s financial health. FCF also accounts for capital expenditures, free cash flow is calculated by:
FCF = Cash From Operations (CFO) – Capital Expenditures
How is operating cash flow different from net income?
Operating cash flow is different from net income, which is the difference between sales revenue and the cost of goods, operating expenses, taxes, and other expenses. When using the indirect method to calculate operating cash flows, net income is one of the default variables. While both metrics measure the financial health of a business, the main difference between operating cash flow and net income is the time difference between sales and actual payments. If payments are late, there can be a difference between net income and operating cash flow.
Bottom Line
Operating cash flow helps determine the financial success of a company’s core business activities and shows whether the company has sufficient positive cash flow to sustain operations. Operating cash flow is one of the three flows listed on a company’s statement of cash flows, along with investing and financing.
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