Operating cash flow or OCF along with other financial metrics proves effective in measuring the financial standing and proficiency of a company. By reviewing the same, investors, creditors and firm owners can make an informed decision about the firm and its future.
Operating cash flow or OCF can be simply described as the measure of cash a company generates through its core business operations within a specific time. It helps to analyse if a company is capable enough to generate the required amount of cash flow to maintain and expand its existing business operations.
In short, OCF serves as an effective benchmark for determining a company’s financial success concerning its operational activities.
Operating cash flow generates money through activities, which include –
Notably, operating cash flow is recorded on a cash flow statement right in the first section. Furthermore, it also highlights a clear demarcation between the cash generated through investing activities and financing activities.
Usually, there are 2 methods of computing operating cash flow or OCF, namely –
1. Direct Method
It is regarded to be a simple formula that helps to obtain accurate results. However, this operating cash formula does not provide much insight to potential investors. Resultantly, it is used mostly by the companies to track their operational performance.
The formula is expressed as,
Operating cash flow = Total Revenue – Operating Expense
2. Indirect Method
In this method, the net income is adjusted by adding the non-cash items to account for the changes in the balance sheet. On the other hand, depreciation is also added to the net income to adjust the changes in cash receivable and inventory.
In other words, the indirect method of calculating OCF requires the addition of non-cash items to the net income and also tunes out the changes in the net capital.
It is further expressed as,
Operating cash flow = Net income (+/-) Changes in assets and liabilities + Non-cash expenditure
Like discussed, the operating cash flow formula can be given by –
OCF = Net Income + Depreciation + Deferred Tax + Stock-oriented Compensation + non-cash items – Increase in Accounts Receivable – Increase in Inventory + Increase in Accounts Payable + Increase in Deferred Revenue + Increase in Accrued Expenses
OCF = Net income + Non-cash expenses – Increase in working capital
Operating cash flow example:
Joe Limited’s financial statements for the financial year 2017 comprise the following information.
Solution: By using the indirect method of operating cash flow,
OCF = Net Income (+/-) Changes in Assets and Liabilities + Non Cash Expenses
= Rs.(100000 – 50000 + 20000 – 25000 – 10000)
Importance of operating cash flow is as follows –
It essentially is a measurement of a company’s capability to cover its current liabilities with the help of the cash generated through its main operations. It is calculated by dividing a company’s total operating cash flow by its current liabilities.
Typically, the ratio proves effective in assessing the liquidity of a company in the short-term. When pitted against net income, operating cash flow is considered to be a more transparent way of measuring a company’s earnings. It is mainly because operating cash flow is more challenging to manipulate.
The operating cash flow ratio formula is expressed as –
OCF ratio = OCF or Operating Cash Flow / Current Liabilities
Suppose, Doubtfire Limited has generated an operating cash flow of Rs.250000. It has also accumulated current liabilities of Rs.120000. From the given information, ascertain its operating cash flow or OCF ratio.
As per the information,
OCF ratio = Operating Cash Flow / Current Liabilities
Notably, a higher than 1 OCF ratio signifies that a firm has generated more money than what it needs to pay off its liabilities. On the other hand, a ratio of less than 1 suggests that the firm has not generated enough to meet its current liabilities and needs more capital.
Nonetheless, it must be noted that a low ratio does not always suggest poor financial standing. In fact, it may indicate a fruitful investment opportunity.
The basic differences between the two are highlighted in this table below –
|Operating Cash Flow||Net Income|
|It is the cash generated through the core operations of a company.||It is essentially the profit earned within a period.|
|It serves as a measurement of a company’s daily cash inflow and outflow concerning its operations.||Net income serves as the starting for computing a company’s operating cash flow.|
|It serves as a metric of a company’s capability to pay off its debt in the short-term.||It is a crucial measure of a company’s profitability and a driver of bond valuation and stock pricing.|
|OCF projects a more transparent image of a company’s finances.||In case of net income, there is room to manipulate the figures.|
|High operating cash flow indicates a greater cash inflow than outflow.||A company with a positive OCF can still have negative net income.|
|OCF formula = Net Income (+/-) Changes in Assets and Liabilities + Non-Cash Expenses||Net income formula = Total revenue – Total expenses|
Therefore, if investors and financial analysts wishing to obtain a transparent report of a company’s finances, they should check its operating cash flow or OCF. Also, for a better idea of its proficiency and financial standing, they may use the OCF ratio along with other financial metrics.