Operating cash flow (OCF) is the cash a business generates through routine operating activities, such as service delivery, marketing, hiring, and payroll, over a specified period. OFC represents a company’s ability to make money in the short and long term. Focusing on operating cash flow metrics helps businesses understand whether they can continue to grow and expand their business. OCF is also important for assessing overall organizational performance and financial health.

Here are the articles to explain, What is operating cash flow? type and importance

For any business to generate income, it must maintain a positive operating cash flow daily as it is directly related to net income. Cash flow management software helps companies and accounting teams manage money coming in and going out. It can also forecast future cash flows using historical financial data as a reference point.

Type of cash flow

Cash flow measures how much money is moving in and out of a company. A business considers valuable when it can generate positive cash flow or have more inflows than outflows.

  • Operating Cash Flow: Cash collected from regular business operations, including sales of goods, rent, wages, overhead, etc.
  • Investing cash flows: The funds used to purchase capital assets and securities such as stocks, bonds, and related holdings are investing cash flows. Cash flow into the company comes primarily from interest and dividends paid on these holdings.
  • Financing cash flows: Cash generated from the capital, external investments, and loans are financing cash flows. It also includes amounts recovered from debt and equity and additional corporate payments.
  • Free Cash Flow (FCF): The money left over after a business pays its operating expenses (such as salaries and taxes) is called free cash flow. Companies can spend their FCF however they want. Operating free cash flow often provides great insight for investors when reviewing business plans and making investment decisions based on the company’s financial efficiency.

The importance of operating cash flow

OCF is a major component of any financial analysis as it demonstrates the sustainability and financial stability of a business. Since operating cash flow takes into account day-to-day activities, it is necessary to determine whether current transactions are profitable.

OCF is an integral part of a company’s earnings assessment. It focuses on cash items that can help determine whether a business will need outside funding or investment shortly.

If an organization generates significant operating cash flow but reports a lower net income value, this implies an increase in the number of fixed assets and accelerated depreciation throughout the transaction.

Operating cash flow is important for the following stakeholders to make sound business decisions:

  • Financial Analysts: OCF is interested in analysts because it indicates whether a company is financially stable and profitable.
  • Investors: OCF helps investors decide whether a business is worth their capital and offers them a good return on their investment.
  • Lenders: Financial institutions such as banks, loan unions, and credit unions evaluate OCF values ​​to determine an organization’s creditworthiness and financial responsibility for lending.

How to Present Operating Cash Flow

They are usually the first part of the financial statements, reported under the statement of cash flows, and include investing and financing cash flows. There are two ways of describing operating cash flow.

Indirect method:

The indirect method first adjusts net income at the bottom of the income statement to the cash basis. Net income needs to adjust because most businesses report on an accrual basis, which means there are small financial gains over time.

Non-cash items such as depreciation, amortization, accounts receivable (AR) and accounts payable (AP) add to arrive at the cash figure. When a company raises an AR increase, revenue generates but cash has not yet been received. In this case, the AR value must subtract from net income to understand the true cash impact on the business.

Likewise, an increase in AP indicates that expenses incurred have not been repaid. This results in the AP amount being added to net income to determine the actual cash impact.

Direct Method:

The direct method expresses operating cash flow and starts by recording cash-based transactions and tracking them during the accounting period.

When using the direct method to display the OCF value, the company still needs to separately perform the indirect method of operating cash flow to reconcile funds to obtain absolute cash figures.

Items included when presenting OCF by the direct method:

  • employee salary
  • Vendors and Vendor Payments
  • cash collected from customers
  • Interest Income and Dividends
  • Income tax and related interest payments

How to Calculate Operating Cash Flow

Reading cash flow and income statements can be challenging without knowing how to calculate the different metrics. Financial analysts can measure how a business conducts cash-based transactions by calculating operating cash flow.

While the simplest form of calculating OCF is Gross Revenue Operating Expenses, the formula may vary from business to business. Every organization has different non-cash items, changes in assets, and financial liabilities. Regardless of how OCF calculates, all items on the income statement and balance sheet must consider.

Calculate the change in operating cash flow:

  • OCF = Net Income + Non-Cash Expenses – Increased Working Capital
  • OCF = Net Income + Depreciation + Stock-Based Compensation + Deferred Taxes + Other Non-Cash Items – Increased AR – Increased Inventory + Increased AP + Increased Accruals + Increased Deferred Revenue
  • The operating cash flow ratio is a measure of whether a company can use the cash it generates to pay its current liabilities. It helps in assessing the short-term liquidity of a business with a transparent view of the company’s total revenue.

OCF Ratio = Operating Cash Flow / Current Liabilities

Operating Cash Flow Example

Let us take a simple example to better understand cash flow from operations. A small business collects $50,000 in cash from its customers. It spent $2,500 on marketing, skills training, and advertising. Assume its current office space depreciates by $1,000 in the same fiscal year, while 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

So OCF – $35,000.

Operating cash flow vs. net income vs. cash earnings per share

  • Several financial indicators help assess the economic performance of a business. But two common metrics that stand often confused with OCF are net income and cash earnings per share (cash earnings per share).
  • Operating cash flow takes into account the amount of cash generated from normal business activities. It is part of the cash flow statement and calculates on an accrual basis.
  • Net income is gross income from sales, including investments and excluding expenses. The main difference between OCF and net income is the way a company recognizes revenue over a certain period and matches expenses to that revenue.
  • Both OCF and net income may be higher or lower depending on the type of financial principle and when it measures.
  • Cash earnings per share is a measure of cash flow based on the number of shares outstanding. Cash EPS indicates operational stability and helps to compare business and financial trends in the market.
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