Operating Cash Flow (OCF): Definition, Importance & Methods?

Each business needs an indicator that can assess the company’s operational progress. This also assists the investor or creditors in predicting if the company is generating sufficient income to support or expand the main functions of a company. This idea of a calculation is also important in predicting the financial performance and solvency of a company.

Key Takeaways

1. Operating cash flow (OCF) is considered the amount of cash a company generates (or consumes) from its operating activities in a particular period of time. 
2. The operating cash flow calculation will always include the following three components: 1) net income, 2) plus non-cash expenses, and 3) minus the net increase in net working capital.
3. Financial analysts analyze a company’s profitability by examining its operating cash flow (OCF), free cash flow (FCF), and net income.

What is Operating Cash Flow?

Operating Cash Flow (OCF) is defined as Cash generated from a company’s normal business operations. It helps the company know whether it has enough positive cash flow to maintain and grow its operations without external financing. A company’s statement of cash flow includes three types of cash flow: operating, investing, and financing.

Operating cash flows capture all the revenue and expenses directly linked to the company’s core operations, including the sale of goods, provision of services, cost of materials, and employees’ wages. Borrowing funds, purchasing capital equipment, and making any payment, like paying dividends to shareholders, are also outside the definition of investing and financing activities.

Why is Operating Cash Flow Important?

Operating Cash Flow (OCF) shows how a business is self-sustainable in terms of generating an ongoing profit relying totally on standard business operations.

This is necessary from a few perspectives:

• Financial analysts: Financial analysts pay special attention to operating cash flow, especially for large companies. Because it shows the overall health and profitability of a business, it’s an important indicator of the company’s financial status.

• Investors: Investors need to put their capital into something that will grow and offer a lot of money. A healthy Operating Cash Flow will introduce confidence in investors and will provide them proof that you can generate an ROI on their investment.

• Lenders: When financial institutions do credit assessments, they assess the risk of being able to get their money back. A favorable OCF allows a business to increase its chances of getting approved for the loan.

The main perspective is that of business owners. You must be in tune with your business’s ability to generate a profit on its own. Record the metric over time so that you can see when your business is becoming more profitable and then dig into why.

What are the Methods of Operating Cash Flow?

There are two types of operating cash flow, the two of them are mentioned below: 

1. Indirect Method

Using the Indirect method, net income is adjusted to a cash basis using changes in non-cash accounts, such as accounts receivable (AR), depreciation, and accounts payable (AP). Because many companies report net income on an accrual basis, it includes many non-cash items.

OCF = NI + D&A – NWC

Where: 

• NI equals the company’s net income
• D&A is depreciation and amortization
• NWC is the increase in net working capital

Net income should be adjusted for changes that occurred in respect of working capital accounts from the balance sheet. For instance, an increase in AR means that the company reported the revenue earned through net income, although the Cash has yet to be received. This increase in AR must be subtracted from net income to trace the real cash effect of these transactions.

On the other hand, an increase in AP indicates that the expenses were made and recorded on an accrual basis, which has yet to be paid for. This increase in AP would have to be added back to net income in order to ascertain the real cash effect.

2. Direct Method

The second method is the direct method, through which a company records all the tractions on a cash basis and shows all the information using the actual cash inflows and outflows during the accounting period.

Below mentioned are the items that are involved in the presentation of the direct method:

• Salaries that have been paid to employees
• Cash that has been paid to vendors and suppliers
• Cash collected from customers 
• Interest income and dividends received
• Income tax paid and interest paid

Compared to the indirect method, this one is simpler and has fewer factors to consider. Although it only records cash revenues and expenses.

Below mentioned is the formula to calculate it:

OCF = Cash Revenue — Operating Expenses Paid in Cash

Operating Cash Flow Formula with Example

If you are an accountant, a financial analyst, or a private investor, you need to know how much cash flow was generated in the period. Sometimes, we pay more attention to the financial statements to see how many stages are present in the calculation process.

Let me explain the operating cash flow formula and each of the constituents as well.

Formula (Short form):

Operating Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital

By using the short-form version of the operating cash flow formula, we can see the basic elements in every OCF calculation.

• Net Income: Net income is what remains after after-tax cost of sales, operating expenses, interest, taxes, and depreciation have been deducted from gross profit at the end of an income statement. It is an unadjusted cash flow statement that directly relates to the income statement.

• Non-cash Expenses: Non-cash expenses are all expenses that have been incurred or accrued during the period but have not necessarily been paid for with Cash or credit. Some examples of non-operational Cash expenses include depreciation and amortization, stock-based compensation, deferred tax, impairment, and changes in unrealized gains and losses.

• Non-cash Working Capital: Non-cash working capital is defined as total current assets minus total current liabilities, excluding cash and debts. This shows that an increase in current assets leads to a decrease in Cash, while an increase in current liabilities leads to an increase in Cash.

Formula (Long form):

Operating Cash Flow = Net Income + Depreciation & Amortization + Stock-Based Compensation + Deferred Tax + Other Non-Cash Items – Increase in Accounts Receivable – Increase in Inventory + Increase in Accounts Payable + Increase in Accrued Expenses + Increase in Deferred Revenue

The formulas above are generally meant to explain to the user how the formula could be calculated and are not strictly complete.

Additional non-cash items and movements in current assets or current liabilities can differ from what is described. That is why it is necessary to ensure that all these points are approved or adapted according to the specifics of the given company and that all items are included in the checklist.

Example of Operating Cash Flow using Practical Example (Amazon)

Let’s calculate the Operating Cash Flow for Amazon Inc. using the indirect method.

Below is hypothetical financial data for the company:

Financial Metric	Amount (in $)
Net Income	120,000
Depreciation & Amortization	30,000
Increase in Accounts Receivable (AR)	(15,000)
Increase in Accounts Payable (AP)	12,000
Increase in Inventory	(10,000)

Step-by-Step Calculation:

Start with Net Income:
Amazon’s net income for the period is $120,000.

Add Non-Cash Expenses:
Depreciation and amortization expenses of $30,000 are added back because they don’t involve cash outflow.

Adjust for Changes in Working Capital:

• The increase in accounts receivable ($15,000) indicates that Amazon hasn’t received this cash yet, so it is subtracted.

• The increase in accounts payable ($12,000) means the company has delayed cash outflows for its payables, so it is added back.

• The increase in inventory ($10,000) represents costs tied up in unsold goods, so it is subtracted.

Operating Cash Flow Calculation:

OCF=120,000+30,000−15,000+12,000−10,000=137,000OCF = 120,000 + 30,000 – 15,000 + 12,000 – 10,000 = 137,000OCF=120,000+30,000−15,000+12,000−10,000=137,000

Thus, Amazon’s Operating Cash Flow (OCF) for the period is $137,000.

Do you know the difference between operating cash flow and net income? Let’s understand this using a table: 

Operating Cash Flow VS Net Income

The difference between the two is mentioned in the table below:

Definition	Cash generated from core business operations.	Profit earned over a specific period.
Measurement	Measures cash inflows and outflows related to daily operations.	Serves as a starting point for calculating operating cash flow.
Debt and Profitability Insights	Indicates a company’s ability to cover short-term debt.	The key indicator of overall profitability and stock pricing.
Transparency	Provides a clearer, more accurate view of financial health.	It can be adjusted or manipulated to change reported profit.
Cashflow Vs. Profit	A company with positive OCF can still have negative net income.	Positive net income may not always mean high cash inflow.
Formula	OCF = Net Income (+/-) Changes in Assets & Liabilities + Non-Cash Expenses	Positive net income may not always mean high cash inflow.

Operating Cash Flow VS Free Cash Flow 

OCF differs from FCF because capital expenditures must be deducted when calculating FCF. OCF and FCF are major indicators of organizational performance, normally used to establish whether an organization’s cash flow is adequate to finance its expenses.

FCF = Cash from operations (CFO) — Capital Expenditures

Operating cash flow is one of the common accounting practices that assist companies in determining the possibilities of turning a profit from the regular course of business. 

This number is useful because, in addition to revenue, it enables one to know how much capital has actually been generated, as well as the earnings made after taxes, depreciation, and other operating costs have been considered.

Wrapping Up…

Operating cash flow contributes to the financial success of a firm’s key business activities and determines whether the company has enough positive cash flow to continue operations. It is one of three flows mentioned on a company’s cash flow statement, alongside investment and financing.