Operating cash flow: what is it and how does it work?
Operating cash flow (OCF) is an important metric to understand. It is used to calculate the financial success of a company’s critical activities. OCF is the first section shown on a cash flow statement. You can describe operating cash flow in two ways.
- Using the indirect method
- Using the direct method
This article will take a closer look at operating cash flow, what it is and how it works.
The indirect method
This method includes net income from an income statement. In addition, using this method, net income is adjusted on a cash basis using changes in non-cash accounts. For example, depreciation, accounts receivable, and accounts payable. When using the indirect method, the net income must change. To clarify, it needs to change for new developments in working capital accounts on the company’s balance sheet.
Let’s break this down even further. An increase in accounts receivable indicates that revenue has been earned and reported in net income on an accrual basis. However, the recipient has not yet received the money. Thus, the increase in accounts receivable should be subtracted from net income. This must occur in order to find the true cash impact of transactions.
On the other hand, an increase in payments on account shows that expenses have been acquired and recorded but remain to be paid. To find the true cash flow impact, the increase must be added back.
The direct method
This method traces every transaction within a defined time frame on a cash basis. Examples of items included in the direct operating cash flow method include…
- Salaries paid to employees
- Cash paid to vendors and suppliers
- Collection from customers
- Interest income and dividends received
- Income tax paid and interest paid
Cash flow from operations focuses on cash inflows and outflows directly associated with core business activities. This includes the sale and purchase of inventory, the provision of services and the payment of salaries.
Understanding Operating Cash Flow
The OCF is the most accurate way to measure the financial success of a company’s core activities. This metric calculates the amount of cash brought in by a company’s standard business operations. If a business is unable to generate adequate positive cash flow, it may be necessary for the business in question to seek external financing for capital expansion.
For a better understanding of operating cash flow, it is important to gain a solid understanding of a cash flow statement. For example, cash flow directly related to operating cash flow focuses on the amount of money a business makes from the revenue it generates.
Many variables can affect OCF. Some of the most important variables include…
- Accounts Receivable Revenue
- Debit interest paid on notes payable
It is important to understand that if your business relies on external investments and/or additional sources of cash, you will most likely have strong cash flow. However, this number will not necessarily reflect whether your business is truly profitable or not. If you remove that income from the equation, you’ll have a more accurate cash flow figure. The calculation of operating cash flow is generally used by large companies. However, if your business generates a lot of outside revenue, it can be useful to determine your operating cash flow.
Operating cash flow formula:
Let’s take a closer look at the OCF formula and how you can calculate this metric for business purposes.
OCF = total cash received for sales – cash paid for operating expenses
Other terms used for this formula include…
(income – operating expenses) + depreciation – income taxes – change in working capital
net income + depreciation – change in working capital
net income – changes in working capital + non-cash expenses
Also, operating cash flow is a reliable and efficient way to show accurate business profitability. For example, suppose Company X currently has net cash from operating activities of $50,000…but the owner of Company X has also invested in the nearby small store, which pays the owner a profit on his investment quarterly.
If the owner were to include the $18,000 he received in the profits of the small store next door, it would significantly increase his net cash flow. That said, it would also result in an unreliable view of the company’s profitability. The reason for this is that the $18,000 received from their investment has nothing to do with whether or not the owner makes a profit directly from Company X.
Final Thoughts on Operating Cash Flow
It is important for every investor to understand how operating cash flow works. Additionally, knowing the financial success of your company’s core business activities is crucial to maintaining and sustaining a profitable business.