What is Operating Cash Flow: An Introduction to the Basics

What is Operating Cash Flow: An Introduction to the Basics

Operating cash flow (OCF) is one of the most important metrics to measure a company’s financial performance. It is the cash a business receives from its operations and uses to pay for day-to-day expenses, investment expenses, and other financial obligations. You might want to understand OCF because it can provide insight into the company’s ability to generate cash and invest in future growth. Knowing the basics of OCF, business owners and investors can evaluate a company’s financial health more accurately and make informed decisions. 

In this article, we will overview the basics of operating cash flow, its components, and its importance in assessing the financial health of a business.

What is operating cash flow?

Operating cash flow is an important benchmark to measure the financial success of a company’s core business activities. It allows one to analyze the income generated from operations and assess a company’s ability to manage its resources efficiently to maintain and grow its operations.

A business might want to strive for a positive operating cash flow to remain profitable and continue operations without interruption. Companies with a positive OCF can remain competitive in their industry and are more likely to succeed in their long-term goals.

Operating cash flow also helps investors evaluate whether or not investing in a particular company will be beneficial. A strong operating cash flow indicates that the company has enough money to cover operational expenses, which makes it an attractive option for potential investors.

Two methods of presenting operating cash flow

Generally accepted accounting principles (GAAP) recognize two methods for presenting operating cash flow information – indirect and direct. 

The indirect method begins with net income and then adjusts for non-cash items like depreciation and amortization, as well as changes in working capital such as inventory and accounts receivable. This method allows for a better understanding of the cash flow from operations since it considers all changes in working capital, including those that are not necessarily related to cash transactions.

On the other hand, the direct method presents information about cash received from customers and cash paid to suppliers and employees instead of adjusting profit or loss for items such as depreciation and amortization. Though this approach does not provide as much detail as the indirect method, it reflects cash flows generated by operating activities more accurately.

How to calculate operating cash flow

The indirect method of calculating operating cash flow is used to adjust net income from an accrual basis to a cash basis. This process involves adding non-cash items such as depreciation and amortization and adjusting accounts receivable and accounts payable. Taxes are also taken into account when calculating operating cash flow.

Now, the formula might slightly differ depending on the character of the business. But basically, the formula for operating cash flow is as follows:

OCF = Net Income + Depreciation and Amortization – Change in Working Capital

This formula might also include non-cash items other than amortization and depreciation (we’ll get to it a little further).

It’s worth mentioning that understanding the different components of this equation is necessary to obtain an accurate result.

Operating cash flow components (and where to find them)?

As previously mentioned, you can calculate operating cash flow by looking at its components, including net income, depreciation and amortization (and other non-cash items), and changes in working capital. 

Net income is the company’s total profit after subtracting any expenses incurred during the accounting period. 

Depreciation and amortization are non-cash expenses that are used to account for the cost of assets over time. 

Changes in working capital refer to changes in the company’s current assets and liabilities during the given period, such as accounts payable and accounts receivable. 

Other non-cash items include stock-based compensation, pension costs, and gain or losses on asset sales. 

To have accurate numbers on these components, you need to know where to find those on financial statements, namely, the cash flow statement. Usually, the cash flow statement starts with the Cash Flow from Operating Activities section, and you’ve got everything you need there.

Why is operating cash flow important?

Operating cash flow is a key metric for understanding the performance of a business. It provides a comprehensive picture of the current financial condition and operations of the business, by showing both its inflows and outflows of cash. Further, it helps to identify potential trends in cash flow and can help to anticipate future problems.

By analyzing the operating cash flow, businesses can identify which activities are generating the most revenue, and which ones are consuming the most cash. For example, a decrease in operating cash flow may be due to an increase in expenses – such as higher wages or increased marketing costs – or a decrease in sales. In either case, the analysis of operating cash flow can provide valuable insights on how to improve the business operations.

The analysis of operating cash flow is particularly important when making decisions about capital investments and acquisitions. By understanding the actual costs associated with an investment or acquisition, businesses can determine whether or not it is feasible to move forward with the decision. Additionally, when considering financing options, an analysis of operating cash flow can provide useful information on how borrowing will affect future cash flows.

Conclusion

Operating cash flow is an important metric that can give you plenty of insights into a company’s financial health and ability to meet its obligations. It is calculated by taking the net income, adding non-cash expenses such as depreciation or amortization, and adjusting for any changes in working capital. By looking at the operating cash flow, you can get how efficiently the business is operating and if it has the necessary resources to meet its financial obligations. This way, it is important to pay attention to the operating cash flow to keep track of the financial health and stability of a company.

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Volha Belakurskaja

Volha Belakurskaja

Volha is an experienced copywriter with 10+ years experience writing for the information technology and services industry and a 5+ years sole proprietorship background. Passionate about all things tech, she is especially interested in topics lying at the confluence of business and technology.

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