Operating cash flow

Key takeaways

• Financial health indicator: OCF gauges a company's ability to generate cash from core business activities.
• Focus on core operations: OCF excludes cash transactions from investing and financing activities.
• Calculation methods: Indirect and direct methods are used to calculate OCF.
• Accurate representation: OCF provides a clearer picture of a company's financial position.
• Sustainability: Positive, consistent OCF is crucial for long-term stability.
• Comprehensive analysis: Compare OCF with other financial metrics, such as FCF and net income, for a complete understanding.

How to Calculate Operating Cash Flow

There are two methods for calculating operating cash flow: the indirect method and the direct method.

Indirect Method:

The indirect method starts with net income from the income statement and adds back non-cash items to arrive at a cash basis figure. The formula for the indirect method is:

OCF = Net Income + Non-Cash Expenses + Changes in Working Capital

Non-cash expenses include items like depreciation and amortization. Working capital is the difference between current assets (cash, accounts receivable, inventory) and current liabilities (amounts due to creditors).

Direct Method:

The direct method uses actual cash inflows and outflows from business operations, instead of adjusting the net income figure. The formula for the direct method is:

Operating Cash Flow (Direct) = Cash Inflows – Cash Outflows

Cash inflows include revenues from the sale of goods and services, while cash outflows comprise costs of running the business, such as rent, wages, and marketing expenses.

An example of calculating operating cash flow

Let's consider a real-life example of operating cash flow using a hypothetical company, ABC Manufacturing Inc.

ABC Manufacturing Inc. is in the business of producing and selling industrial equipment. To assess its financial health, we need to analyze its operating cash flow. The company's financial data for the previous year are as follows:

• Net income: £500,000
• Depreciation and amortization: £200,000
• Increase in accounts receivable: £50,000
• Increase in inventory: £100,000
• Increase in accounts payable: £150,000

We will use the indirect method to calculate the operating cash flow:

1. Start with net income: £500,000
2. Add back depreciation and amortization: £500,000 + £200,000 = £700,000
3. Adjust for changes in working capital:
• Subtract the increase in accounts receivable: £700,000 - £50,000 = £650,000
• Subtract the increase in inventory: £650,000 - £100,000 = £550,000
• Add the increase in accounts payable: £550,000 + £150,000 = £700,000

Operating Cash Flow = £700,000

In this example, ABC Manufacturing Inc.'s operating cash flow is £700,000. This indicates that the company generated £700,000 in cash from its core business operations during the previous year. A positive operating cash flow is a good sign, as it shows that the company can sustain its operations and potentially grow without relying on external financing.

Why is Operating Cash Flow Important?

Operating cash flow is a crucial benchmark for assessing the financial success of a company's core business activities. It provides a clearer picture of the company's current financial health by excluding certain accounting anomalies. Analysts often prefer cash flow metrics because they offer a more accurate representation of the company's performance.

A sustainable positive operating cash flow is essential for a company's long-term stability. If a company cannot generate sufficient cash from its core business operations, it may need to rely on temporary external funding through financing or investing, which is unsustainable in the long run.

Key Differences Between Operating Cash Flow, Free Cash Flow, and Net Income

Operating cash flow differs from free cash flow (FCF) and net income.

Free cash flow is the cash a company generates after accounting for operations and other cash outflows, such as capital expenditures.

It is calculated using the formula:

FCF = Cash from operations – Capital Expenditures

Net income, on the other hand, represents the difference between sales revenue and costs of goods, operating expenses, taxes, and other costs. While both net income and operating cash flow can be used to measure a company's financial health, the main difference between them lies in the timing of sales and actual payments. If payments are delayed, there may be a significant discrepancy between net income and operating cash flow.