What is Operating Cash Flow? The Formulas & Calculation Methods

What is Operating Cash Flow (OCF)?

Operating cash flow refers to the amount of revenue a company generates under its normal business operations. This will include cash inflow and outflows through its core business activities.

This measure can help investors understand whether a company is a good opportunity to invest in based on its financial health to conclude if the company has enough capital to pay for its operating expenses.

Management often uses OCF as a tool for strategic decision-making. A company with a healthy OCF has the flexibility to invest in growth, pay down debt, or return value to shareholders. It plays a pivotal role in shaping the financial strategy and sustainability of any business.

Calculating Operating Cash Flow

A cash flow statement contains three sections: operating cash flow, investment cash flow, and financing cash flow. Calculating operating cash flow excludes all investment cash flow and financing cash flow activities.

Wave Accounting provides a formula you can use to calculate OCF. This basic formula is called the: “direct method,” which does not account for adjustments such as non-cash items and changes in the working capital:

Operating cash flow = total cash received for sales - cash paid for operating expenses

However, there’s another formula called the indirect method which we will cover further in this article. Through this formula, you can get valuable insights into a company’s ability to convert its operational ability into a monetary return, as well as assess its financial liquidity.

Operating cash flow is calculated through a period, meaning either monthly, quarterly, or yearly. The data received for sales and operating expenses should meet those specific timeframes.

Operating Cash Flow Examples

There are many ways you can find out what your current cash flow is. The first step is to find out your cash inflows and outflows. Here are what counts as a cash-inflow and cash-outflow:

Cash Inflows:

• Revenue generated from sales of goods and services. (sales revenue)
• Dividend income in the form of investments into other companies.
• Royalty payments for the use of intellectual property.

Cash Outflows:

• Cash payments to acquire materials to provide a service or manufacturing.
• Cash payments for employee salaries.
• Cash payments towards suppliers.
• Cash payment towards taxes, duties, and other fees and penalties.

Since the OCF only deals with core business activities, it excludes any cash inflows and outflows received from loan proceeds and financing.

Direct and Indirect Methods

There are two methods commonly used to calculate OCF in the cash flow statement. They are the direct method and the indirect method:

Direct Method

• The direct method calculation is derived by examining cash transactions related to operating activities.
• It involves listing all the major cash inflows and outflows associated with operating activities.
• Examples of cash inflows include cash received from customers, interest received, and dividends received.
• Cash outflows include payments to suppliers, employee wages, and operating expenses.

The formula for calculating operating cash flow using the direct method is:

OCF = Cash Inflows − Cash Outflows

Advantages of the Direct Method

Transparency: The direct method provides a more straightforward and transparent view of cash inflows and outflows from operating activities. It directly lists cash receipts and payments.

User-Friendly: For users of financial statements, especially investors and analysts, the direct method is generally considered more intuitive, as it clearly shows the actual cash transactions related to operating activities.

Operational Insights: It offers insights into the specific cash flows related to major operating activities, allowing for a more detailed understanding of a company's cash-generating sources.

Things to Consider

Data Availability: The direct method may require more detailed information on specific cash transactions, which could be challenging for companies with complex operations or decentralized accounting systems.

Implementation Effort: Switching to the direct method may require changes to accounting systems and processes to capture and report cash transactions directly.

Indirect Method

• The indirect method starts with the net income from the company's income statement and adjusts it for non-cash items and changes in working capital to derive the operating cash flow.
• It is more commonly used, as companies typically prepare their financial statements using the indirect method due to its simplicity.
• The adjustments involve adding back non-cash expenses (e.g., depreciation and amortization) and accounting for changes in working capital accounts (e.g., changes in accounts receivable, accounts payable, and inventory).
• The indirect method is derived from the accounting equation: (Assets = liabilities + equity)

💡Tip: There are modern tools you can use to calculate OCF quickly, as these calculations are available in most accounting software.

The formula for calculating using the indirect method is:

OCF= net income + Non−cash Expenses − Changes in Working Capital

Let’s break down each section and their definitions:

Net income. Net income is also called net earnings. It is calculated with sales minus the cost of goods sold, general expenses, taxes, and interest.

Non-Cash Expenses. Non-cash expenses are business costs that don’t involve any cash transactions. For example, depreciation, amortization, bad debt expenses, and stock-based compensation. We will quickly break down each definition separately.

• Depreciation is the gradual decrease in the value of an asset over time.
• Amortization is the process of spreading the cost of an intangible asset over its useful life, amortization is used for intangible assets such as patents, trademarks, copyrights, and goodwill.
• Bad debt expenses are debt that is unpaid to customers in the case of a loan.
• Stock-based compensation refers to a method companies use to reward their employees by offering them shares of the company's stock or the right to buy shares at a predetermined price.

Change in working capital. Changes in working capital refer to the fluctuations regarding a company’s assets and liabilities. The formula to calculate changes in working capital is as follows:

Change in working capital = current assets at the end of the period - current liabilities at the end of the period

Using the net income, non-cash expenses, and changes in working capital, you can calculate operating cash flow with the indirect method. A key benefit of the indirect method is that it’s consistent with financial statements and more closely aligned with the accrual accounting used.

Advantages of the Indirect Method

• Simplicity: The indirect method is generally simpler to implement as it starts with net income and adjusts for non-cash items and changes in working capital.
• Consistency: Many companies prefer the indirect method because it aligns with standard accounting practices and is more commonly used in financial reporting.
• Less Granularity: It may be less detailed than the direct method, making it suitable for companies where a more aggregated view of cash flow is sufficient.

Things to Consider

• Subjectivity: Adjustments in the indirect method involve subjective decisions, potentially making it less transparent and clear in terms of the specific operating cash flow components.
• Understanding Working Capital Changes: Users need to understand the changes in working capital accounts (e.g., accounts receivable and accounts payable) to interpret the adjustments correctly.

How to Choose Between Direct and Indirect Methods?

Here are some factors you should consider when choosing between direct and indirect methods to calculate the operating cash flow:

• Regulatory Requirements: Some regulatory bodies or accounting standards may have specific requirements or preferences regarding the use of the direct or indirect method.
• User Preferences: Consideration should be given to the needs and preferences of the users of the financial statements, including investors, analysts, and creditors.
• Operational Complexity: The complexity of a company's operations and the availability of detailed cash transaction data may influence the choice of method.

Operating Cash Flow vs Net Income

It’s common for newer companies to generate a low net income but be high on operating cash flow as they invest in the expansion of their businesses. Vice versa, some companies have a high net income while having a low operating cash flow.

In this scenario, while a high net income may indicate that a company is generating a profit, a low operating cash flow could suggest that the company has delayed payments to suppliers or has extended credit to its customers.

Investors and analysts must analyze both OCF and net income to get a clearer picture of a company’s financial health. Disparities between both statements may show that there are specific drivers within the organization that are causing this performance.

Here is a table to further help illustrate the differences:

Net income and operating cash flow are different indicators of a company’s financial health. Being healthy on one, say, cash flow, may not necessarily mean there’s a high net income, and vice versa. Here are six scenarios in which net income and operating cash flow differ and their respective outcomes:

Scenario 1: Positive Net Income, Negative Operating Cash Flow:

Explanation: A company reports a positive net income due to substantial sales and revenues. However, its operating cash flow is negative because it has high levels of accounts receivable, indicating that customers are taking longer to pay their bills. This suggests potential cash flow challenges despite profitability on paper.

Scenario 2: Negative Net Income, Positive Operating Cash Flow:

Explanation: A startup or a growing company may incur significant expenses, resulting in a negative net income. However, its operating cash flow is positive because it's effectively managing its working capital and collecting payments from customers promptly. This suggests the company is operationally sound despite not yet achieving profitability.

Scenario 3: Non-Cash Expenses Impacting Net Income:

Explanation: A company has high depreciation and amortization expenses, causing its net income to be lower. However, its operating cash flow is higher because these non-cash expenses are added back into the calculation. This scenario illustrates the difference between accounting for depreciation in net income and its exclusion in operating cash flow.

Scenario 4: Seasonal Sales Impacting Working Capital:

Explanation: A retail business experiences seasonal peaks in sales, leading to a spike in accounts receivable and inventory. While net income reflects the profitability during the peak season, operating cash flow might be lower due to the increased working capital requirements. This highlights the importance of considering working capital changes in cash flow analysis.

Scenario 5: Rapid Growth with Financing Activities:

Explanation: A company is in a high-growth phase, investing heavily in new projects and expansion. Its net income might be positive, indicating potential profitability in the future, but the operating cash flow might be supplemented by financing activities like loans or equity funding to support the growth initiatives.

Scenario 6: Conservative Accounting Practices:

Explanation: A company follows conservative accounting practices, recognizing revenue and profits only when they are realized. As a result, its net income might be lower than the cash generated from operations, as the company prioritizes a more cautious approach to financial reporting.

Understanding the Operating Cash Flow Ratio

The operating cash flow ratio is a measure of how a company’s current cash flow is being compared to a company’s current liabilities. This ratio can help gauge a company’s liquidity positioning.

What are examples of Liabilities?

To calculate the OCF ratio, you need to also calculate your liabilities. Liabilities are forms of obligation or debt that a company has to pay to external parties.

Liabilities are:

• Debt a company owes to external creditors.
• Accounts payable. Money owed to suppliers or vendors that a company has purchased on credit.
• Obligations in terms of bonds a company has issued and must pay over time.

The Formula for Operating Cash Flow Ratio

Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

So, let’s take the example of a company with $190,000 in operating cash flow with about $120,000 in liabilities.

190,000 / 120,000 = 1.59 operating cash flow ratio

This indicates that a company can cover its liabilities 1.59x over.

Breaking down the Operating Cash Flow Ratio

A positive OCF ratio shows that a company can cover its short-term liabilities while having earnings left over. A negative cash flow ratio shows financial problems, which may lead to short-term challenges in terms of capital.

This ratio is also known as the liquidity ratio, giving an indicator of how much liquidity is available for any given business. It's important to note that the interpretation of the operating cash flow ratio may vary based on industry norms, company size, and specific business dynamics.

How to Analyze Operating Cash Flow?

Analyzing cash flow is key in helping any individual gain insight into a company’s financial health. A positive cash flow shows favorable financial health for a company.

🔍 Insights: Preparing financial statements bi-monthly helps businesses with cash flow management.

Here are the benefits of having positive cash flow:

• Strong business core operations, which helps continue operations.
• A sign of liquidity and financial health.
• Investment capabilities for further business expansion.
• Able to make dividend payments to shareholders.
• An indicator of growth sustainability.
• It can be a factor in building investor confidence.

While a negative cash flow shows that a company is not generating enough cash from its core business activities to cover its day-to-day expenses, it’s also an indicator that a company is in trouble, especially for long periods.

Here are the drawbacks of having negative operating cash flow:

• Liquidity issues make it difficult for businesses to pay daily expenses.
• Inability to invest in growth opportunities to aid company expansion.
• An over-reliance on external funding may dilute founder ownership.
• Stressed relationship with suppliers due to inability to pay on time.
• Higher insolvency risk. A company with negative operating cash flow for long periods may lead to bankruptcy.

How to Make Better Decisions With Financial Statements?

Understanding cash flow is a key part of cash flow management. Using this piece of information, your company can further better make key decisions based on facts rather than on hearsay.

Decisions such as management changes, business development, and investment in growth opportunities should be guided based on a company’s finances. It will be able to dictate what a company can or cannot do.

Increasing a company’s OCF is vital to any business growth & expansion. The “how” comes from clients. Clients are the lifeblood of any business organization, and knowing how to acquire new clients in a profitable way is foremost to any business' success.

Your cash flow dictates your costs, and by implementing sound cost management practices, organizations can not only improve their financial health but also gain a competitive edge in the market.

Conclusion

In conclusion, understanding and effectively managing operating cash flow is paramount for the financial health and sustainability of any business. OCF serves as a crucial indicator of a company's ability to generate cash from its core operations, meet its short-term obligations, and invest in future growth.

By consistently monitoring and analyzing operational cash flow, companies can fortify their financial resilience, adapt to dynamic market conditions, and position themselves for long-term success in an ever-evolving business landscape.