What is operating cash flow?
Operating cash flow (OCF) is the cash generated by a business through regular operational activities, such as service provision, marketing, recruiting, and payroll, within a specific time.
The OFC represents a company’s ability to be profitable in the short and long run. Paying attention to the operating cash flow metric helps businesses understand whether they can continue growing and expanding operations. OCF is also important to assess overall organizational performance and financial health.
For any business to earn revenue, it’s essential to maintain positive operating cash flow every day, as it’s directly tied to net income. Cash flow management software helps companies and accounting teams manage incoming and outgoing funds. It can also forecast future cash flows using historical financial data as a reference point.
Types of cash flows
Cash flows measure how much money goes in and out of a company. A business is considered valuable when it can generate positive cash flow, or more inflows than outflows.
- Operating cash flow: Cash collected from regular business operations, including goods sold, rent, salaries, overhead costs, and others.
- Investment cash flow: Money spent on purchasing capital assets and securities such as stocks, bonds, and associated holdings is investment cash flow. Cash flows into the company primarily from interest and dividends paid on these holdings.
- Financing cash flow: Cash generated from capitals, external investments, and loans fall under financing cash flow. It also includes amounts recovered from debt and equity and additional company payments.
- Free cash flow (FCF): Money left over after a business pays its operating expenses (such as payroll and taxes) is called free cash flow. Companies can use their FCF however they like. Operating free cash flows are typically insightful for investors when reviewing a business plan and making investment decisions based on a company’s financial efficiency.
Importance of operating cash flow
Operating cash flow is a major component of any financial analysis because it gives a clear picture of a business’ sustainability and financial stability. Since operating cash flow considers day-to-day activities, it is necessary to determine whether current transactions bring in a profit.
Operating cash flow is an integral part of a company’s revenue assessment. It focuses on cash items that can help identify whether the business requires external funding or investments in the near future.
If an organization generates high amounts of operating cash flow but reports a low net income value, it signifies an increased number of fixed assets and accelerated depreciation throughout transactions.
Operating cash flow is important for the following stakeholders to make sound business decisions:
- Financial analysts: OCF is of interest to analysts as it indicates whether a company is financially stable and profitable.
- Investors: Operating cash flows help investors decide if a business is worth their capital and will provide good returns on their investment.
- Lenders: Financial institutions such as banks, loan associations, and credit unions assess OCF values to determine an organization’s borrowing credibility and financial responsibility.
How to present operating cash flow
Operating cash flow is usually the first section of a financial statement and is presented under the cash flow statement, including investing and financing cash flows. There are two ways of depicting operating cash flow.
1. Indirect method: The indirect method begins with adjusting the net income at the bottom of the income statement to a cash basis. Net income needs to be adjusted since most businesses report it on an accrual basis, which denotes small financial gains over time.
Non-cash items such as depreciation, amortization, accounts receivable (AR), and accounts payable (AP) are added to arrive at a cash figure. When a company presents an increase in AR, revenue is made but no cash is received yet. In such a case, the AR value must be subtracted from net income to understand the true cash impact on the business.
Similarly, an increase in AP indicates that incurred expenses haven’t yet been paid off. This results in the AP amount being added to net income to determine the actual cash impact.
2. Direct method: The direct method of presenting operating cash flow begins with recording cash-based transactions and tracking them during the accounting period.
When using the direct method to show OCF values, companies still need to separately perform the indirect method of operating cash flow to reconcile funds and arrive at an absolute cash figure.
Items included when presenting OCF through the direct method:
- Employee salaries
- Vendor and supplier payments
- Cash collected from customers
- Interest income and dividends
- Income tax and related interest payments
How to calculate operating cash flow
It can be challenging to read a cash flow and income statement without knowing how to calculate the different metrics. Financial analysts can gauge how a business carries out cash-based transactions by calculating operating cash flows.
While the simplest form of calculating OCF is total revenue operating expenses, the formulae can differ from business to business. Each organization has different non-cash items, asset changes, and financial liabilities. Regardless of how OCF is calculated, it is essential to account for all items on the income statement and balance sheet.
Variations of calculating operating cash flow:
- OCF = Net income + Non-cash expenses - Increase in working capital
- OCF = Net income + Depreciation + Stock-based compensation + Deferred tax + Other non-cash items - Increase in AR - Increase in inventory + Increase in AP + Increase in accrued expenses + Increase in deferred revenue
The operating cash flow ratio is a metric to determine whether a company can use the cash it generates to cover current liabilities. It helps assess a business’ short-term liquidity with a transparent view of the total company income.
OCF ratio = Operating cash flow / Current liabilities
Operating cash flow example
Let’s take a quick example to understand operating cash flow better. A small business collects $50,000 in cash from its customers. It spends $2,500 on expenses such as marketing, skills training, and advertising. Assume that its current office space depreciates $1,000 in the same financial year and that taxes are $12,500.
Net income = $50,000 - $2,500 - $1,000 - $12,500
Net income = $34,000
OCF = Net income + Depreciation
OCF = $34,000 + $1,000
OCF - $35,000
Operating cash flow vs. net income vs. cash earnings per share
Many financial metrics help evaluate a business' economic performance. But the two common metrics often confused with OCF are net income and cash earnings per share (cash EPS).
Operating cash flow takes into consideration cash amounts generated from normal business activities. It’s part of the cash flow statement and calculated on an accrual basis.
Net income is the total income from sales, including investments and excluding expenses. OCF and net income differ primarily in a company’s way of recognizing revenue and matching expenses to that revenue in a certain period.
Both OCF and net income can be higher or lower depending on the type of financial principle and measurement time.
Cash earnings per share is a metric that measures cash flow based on the number of shares outstanding. Cash EPS indicates operational stability and helps compare businesses and financial trends in the market.
Aayushi Sanghavi
Aayushi Sanghavi is a Campaign Coordinator at G2 for the Content and SEO teams at G2 and is exploring her interests in project management and process optimization. Previously, she has written for the Customer Service and Tech Verticals space. In her free time, she volunteers at animal shelters, dances, or attempts to learn a new language.
