Operating cash flow (OCF) refers to the cash a company brings in from its regular business activities. It’s a key indicator of whether a company can generate enough cash to keep its operations running and even expand, all without needing outside funding. In a company’s cash flow statement, you’ll find three categories of cash flows: operating, investing, and financing.
OCF specifically looks at the cash that comes in and goes out from the core business functions, like selling products, buying inventory, offering services, and paying employees. It doesn’t include cash flows from investing or financing activities, like loans, purchasing equipment, or paying dividends.
Accounting for OCF
Operating cash flow shows how cash is affected by a company’s net income from its main business activities. It’s often called cash flow from operating activities and is the first part of the cash flow statement.
This metric gives a straightforward view of how the business is really doing. For instance, a big sale might increase revenue, but if the company struggles to collect that cash, it doesn’t really help the bottom line. Conversely, a company could have strong operating cash flow but low net income if it has many fixed assets and uses accelerated depreciation.
If a company isn’t generating enough cash from its core operations, it might need to seek temporary funding through financing or investing, but that’s not a long-term solution. Operating cash flow is crucial for evaluating the financial health of a company’s operations. The cash flow section can be reported using either the indirect or direct method according to generally accepted accounting principles (GAAP). If the direct method is chosen, the company still needs to reconcile it with the indirect method separately.
Calculation of OCF – Indirect Method
Net income is converted to a cash basis through the indirect method by adjusting for changes in non-cash accounts like depreciation, accounts receivable (AR), and accounts payable (AP). Since most businesses report net income on an accrual basis, it often includes several non-cash elements.
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 needs to be tweaked based on shifts in working capital accounts found on the balance sheet. For instance, if accounts receivable (AR) goes up, it means revenue was recognized and included in net income, even though the cash hasn’t actually come in yet. So, you’d have to subtract that increase in AR from net income to get a clearer picture of the cash flow.
On the flip side, if accounts payable (AP) rises, it shows that expenses were recorded on an accrual basis but haven’t been paid yet. In this case, you’d want to add that increase in AP back to net income to accurately reflect the cash situation.
Calculation of OCF – Direct Method
This approach is easier than the indirect method since it has fewer elements to think about. But keep in mind, it only takes into account cash income and costs. You can calculate it using the formula:
OCF = Cash Revenue — Operating Expenses Paid in Cash
Conclusion
Operating cash flow is key to figuring out how well a company’s main business activities are doing. It shows if the company is bringing in enough cash to keep things running smoothly. You’ll find operating cash flow as one of the three main cash flows on a company’s cash flow statement, alongside investing and financing.