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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.

What is Operating Cash Flow?

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 –

  • Aggregate sales of goods and services within a given period.
  • Payments to goods and service suppliers.
  • Pay-outs forwarded to employees or other expenses incurred for production.

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. 

Methods of Operating Cash Flow

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. 

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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

Operating Cash Flow Formula and Example

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

or,

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.

  • Net income: Rs.100000
  • Depreciation: Rs.10000
  • Change in inventory: Rs.20000
  • Change in accounts receivable: Rs.50000
  • Change in accounts payable: Rs.25000

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)

=Rs.55000

Significance of Operating Cash Flow 

Importance of operating cash flow is as follows –

  • A negative OCF indicates that a company does not have sufficient funds to run its core operations and needs to borrow funds to maintain the same.
  • A relatively high net income may indicate that the firm finds it challenging to collect accounts receivable. 
  • It is considered to be among the purest measures of cash sources and offers a transparent insight into a company’s operational performance.
  •  It serves as a gateway to other reported financial statements.

OCF Ratio

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

= 250000/120000

= 2.08

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. 

Net Income vs Operating Cash Flow

The basic differences between the two are highlighted in this table below –

Operating Cash FlowNet 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 ExpensesNet 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 OFC. Also, for a better idea of its proficiency and financial standing, they may use the OFC ratio along with other financial metrics.

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