Operating Cash Flow: What Is It and How Does It Work?
Operating cash flow (OCF) is an important measurement to understand. It’s used to calculate financial success of a company’s critical activities. OCF is the first section portrayed on a cash flow statement. You can depict the 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 the net income from an income statement. In addition, by using this method, net income is adjusting to a cash basis using changes in non-cash accounts. For example, depreciation, accounts receivable and accounts payable. When using the indirect method, net income needs to 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 was earned and reported in net income on an accrual basis. However, the recipient has yet to receive the cash. So, the increase in accounts receivable needs to be subtracted from the net income. This has to happen in order to find the true cash impact of the transactions.
On the other hand, an increase in account payments show that expenses were acquired and booked but are yet to be paid. To find the true cash impact, the increase needs to be added back.
The Direct Method
This method traces every transaction in a set timeframe on a cash basis. Examples of items included in the direct method of operating cash flow consist of…
- Salaries paid out to employees
- Cash paid to vendors and suppliers
- Cash collected from customers
- Interest income and dividends received
- Income tax paid and interest paid
Operating cash flows focus on cash inflow and outflows that are directly associated to primary business operations. This includes selling and purchasing inventory, providing services and paying salaries.
Understanding Operating Cash Flow
OCF is the most accurate way to measure financial success of a business’s core activities. This measurement calculates the amount of cash brought in by a company’s standard business operations. If a company is not able to generate adequate positive cash flow, it might be necessary for the company in question to bring in external financing for capital expansion.
For a better understanding of operating cash flow, it’s important to gain a solid understanding of a cash flow statement. For instance, cash flow in direct relation to operating cash flow focuses on the amount of cash that a company makes from the revenues it brings in.
Many variable can affect OCF. A few of the most important variables include…
- Accounts receivable turnover
- Interest expense paid on notes payable
It’s important to understand that if your business counts on external investments and or additional cash sources, you’ll most likely experience strong cash flow numbers. However, that number won’t necessarily reflect whether or not your business is truly profitable. If you remove that revenue from the equation, you’ll have a more precise cash flow number. The operating cash flow calculation is generally used by large businesses. However, if your business has a lot of outside revenue flowing in, it can be helpful 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 measurement for business needs.
OCF = total cash received for sales – cash paid for operating expenses
Other terms used for this formula include…
(revenue – 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
In addition, operating cash flow is a reliable and effective way to show accurate business profitability. For instance, let’s say that company X currently has net cash from operating activities in the amount of $50,000… but the owner of company X also invested in the small store next door, which pays the owner profits on their investment quarterly.
If the owner were to include the $18,000 they received in profits from the small store next door, it would raise their net cash flow significantly. Having said this, it would also result in an unreliable view of the profitability of the business. The reason being that the $18,000 received from their investment has nothing to do with whether or not the owner is making a profit directly from company X.
Concluding Thoughts on Operating Cash Flow
It’s important for each and every investor to understand how operating cash flow works. In addition, knowing the financial success of your company’s core business activities is crucial in maintaining and sustaining a profitable business.