In business, you will frequently come across the term “operating cash flow.” What does it mean, though?
This post will give you the definition of operating cash flow (OCF) and then provide an example. We’ll also discuss two different methods for calculating OCF.
Operating Cash Flow: A Definition
Operating cash flow is the cash that businesses generate during normal operations. Companies receive money from customers and clients and then use it to fund wages, rents, bills, marketing, and other services.
The operating cash flow formula is as follows: net income plus non-cash income, adjusted for changes in working capital, revealing total cash generated and spent in a given period.
Operating cash flow, along with free cash flow and net income, helps companies determine their financial health. It provides a real-time view of their current cash position, regardless of their end-of-quarter profitability.
To calculate operating cash flow, you can apply the following operating cash flow equation:
Operating Cash Flow = Net Income + Non-CashExpenses – Increase In Working Capital
You can also calculate operating cash flow per share to see how much revenue each chunk of equity is generating:
Cash Flow Per Share = (OCF – Preferred Dividends) / Common Shares Outstanding
Subtracting preferred dividends (if the company offers them) is essential for calculating this statistic because these shareholders receive cash first.
How To Understand OCF in Accounting
At first, operating cash flow seems like a complex topic. That’s because most people are used to thinking in terms of profit and loss. However, once you understand how OCF works, you’ll quickly see the value it offers.
Operating cash flow enables firms to track cash flows in and out of their business accounts during regular operations. It lets them separate their primary business activities from other factors that influence their balance sheets, telling them how much money they have to play with at any given time.
Operating cash flow, sometimes called “cash flow from operating activities,” is the first section of the cash flow statement. It excludes any investments or financing transactions and includes cash in-flows and out-flows related to:
- Selling and purchasing inventory,
- Paying staff wages,
- Providing services,
- Paying salaries and bonuses,
- Paying suppliers, contractors, and consultants.
Why Would a Company Use Operating Cash Flow?
The beauty of operating cash flow is how it strips out various factors that get in the way of assessing the core health of a business.
For example, a company may have just made a large sale and is waiting for money to enter its accounts. On its year-end profit-and-loss statement, it will record the sale as revenue, making the company appear healthy. However, if the firm cannot collect the money, perhaps because the client pays late, it has no cash inflows – something that a look at the OCF will reveal.
Even so, operating cash flow isn’t always helpful for measuring the financial solvency of a firm. For instance, if capital spending is high and the company applies accelerated depreciation, the operating cash flow will appear chronically low even if the business has enough cash on hand to meet all its needs.
To remedy this, firms also report free cash flow (FCF). This expanded definition of a company’s cash flow avoids the artificial deflation of its total cash reserves, which often appears after working capital increases are taken into account.
Indirect and Direct Methods for Calculating Operating Cash Flow
There are two methods of calculating OCF: indirect and direct.
The indirect method of calculating OCF takes net income and applies various correction factors to it, reflecting the status of non-cash accounts, such as accounts payable, accounts receivable, and capital depreciation. The reason accountants call it “indirect” is because OFC is inferred from the company’s net income position.
An increase in accounts receivable, for instance, indicates that the firm has earned money, but the cash has not yet been received. Therefore, it must be subtracted from the net income.
By contrast, accounts payable implies that the company has incurred expenses, but they have not yet been paid. This extra cash would need to be added back to net income to produce the OCF statistic.
The other method is for the company to record all transactions in cash and summarize its cash position for a particular accounting period on that basis. For instance, it might keep tabs on cash paid to suppliers and vendors, workers, and tax authorities when measuring out-flows, and sources of income, such as sales and dividends, when measuring in-flows.
Operating cash flow is a useful tool businesses use to determine their net cash position. It is valuable because it informs companies about their ability to pay for the inventory and services they need right now, regardless of their profitability. However, free cash flow might be more helpful to companies with accelerating depreciation programs.