Definition of operating cash flow (FCO)
What is operating cash flow (OCF)?
Operating cash flow (OFC) is a measure of the amount of cash generated by the normal business operations of a company. Operating cash flow indicates whether a business can generate sufficient positive cash flow to maintain and grow its business, if not, it may need external financing for capital expansion.
Key points to remember
- Operating cash flow is an important benchmark in determining the financial success of a company’s core activities.
- Cash flow from operations is the first section represented on a statement of cash flows, which also includes cash flows from investing and financing activities.
- There are two methods of representing operating cash flows on a cash flow statement: the indirect method and the direct method.
- The indirect method starts with net income from the income statement, then adds non-cash items to arrive at a basic cash figure.
- The direct method tracks all transactions in a period on a cash basis and uses the actual cash inflows and outflows on the cash flow statement.
Understanding Operating Cash Flow (OCF)
Operating cash flow represents the cash impact of a company’s net income (NI) from its core business activities. Cash flow from operations, also known as cash flow from operating activities, is the first section presented in the statement of cash flows.
Two methods of presentation of the operating cash flow section are acceptable under generally accepted accounting principles (GAAP): the indirect method or the direct method. However, if the direct method is used, the company should always perform a separate reconciliation with the indirect method.
Operating cash flow focuses on the inflows and outflows of cash related to a company’s main business activities, such as the sale and purchase of inventory, the provision of services, and the payment of wages. All investing and financing transactions are excluded from the operating cash flow section and reported separately, such as borrowing, purchasing capital goods and paying dividends. Operating cash flows can be found in a company’s statement of cash flows, which is broken down into cash flows from operations, investing and financing.
How to present operating cash flow
Using the indirect method, net income is adjusted on a cash basis using changes in non-cash accounts, such as depreciation, accounts receivable (AR), and accounts payable (AP). Since most businesses report net income on an accrual basis, it includes various non-cash items, such as depreciation and amortization.
Net income should also be adjusted for changes in working capital accounts on the company’s balance sheet. For example, an increase in RA indicates that income has been earned and reported in net income on an accrual basis even though the money has not been received. This increase in AR must be subtracted from the bottom line to find the true cash impact of the transactions.
Conversely, an increase in PA indicates that expenses have been incurred and recorded on an accrual basis that have not yet been paid. This increase in AP should be added back to the bottom line to find the true impact on cash flow.
Take the example of a manufacturing company that reports net income of $ 100 million, while its operating cash flow is $ 150 million. The difference results from a depreciation charge of $ 150 million, an increase in accounts receivable of $ 50 million and a decrease in accounts payable of $ 50 million. It would appear on the operating cash flow section of the cash flow statement as follows:
|Net revenue||$ 100 million|
|Depreciation||Add $ 150 million back|
|Increased AR||Less than $ 50 million|
|Decreased BP||Less than $ 50 million|
|Operating cash flow||$ 150 million|
The second option is the direct method, in which a company records all transactions on a cash basis and displays the information using the actual cash inflows and outflows during the accounting period. Examples of items included in the presentation of the direct operating cash flow method include:
- Salaries paid to employees
- Cash payment to vendors and suppliers
- Cash collected from customers
- Interest income and dividends received
- Income tax paid and interest paid
Importance of operating cash flow
Financial analysts sometimes prefer to look at cash flow metrics because they eliminate certain accounting anomalies. Cash flow from operations, in particular, provides a clearer picture of the current reality of business operations.
For example, booking a large sale greatly increases revenue, but if the business is struggling to raise the money, it is not of real economic benefit to the business. On the other hand, a business can generate high operating cash flow but report very low net income if it has a lot of fixed assets and uses accelerated depreciation calculations.
If a business does not derive enough money from its core activities, it will have to find temporary sources of external funding through finance or investment. However, this is not sustainable in the long run. Therefore, operating cash flow is an important number in assessing the financial stability of a company’s operations.
What are the three types of cash flow?
The three types of cash flow are operating, investing and financing. Cash flow from operations includes all cash flows generated by the principal business activities of a company. Investing cash flow includes all purchases of fixed assets and investments in other business enterprises. Financing cash flow includes all income from the issuance of debt and shares as well as payments made by the company.
Why is operating cash flow important?
Operating cash flow is an important benchmark in determining the financial success of a company’s core business activities because it measures the amount of cash generated by a company’s normal business operations. Operating cash flow indicates whether a business can generate sufficient positive cash flow to maintain and grow its business, if not, it may need external financing for capital expansion.
How to calculate the operational cash flow?
Using the indirect method, net income is adjusted on a cash basis using changes in non-cash accounts, such as depreciation, accounts receivable, and accounts payable (AP). Since most businesses report net income on an accrual basis, it includes various non-cash items, such as depreciation and amortization. Operating Cash Flow = Operating Profit + Depreciation – Taxes + Change in WCR.