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.

What is Operating Cash Flow?

Operating Cash Flow (OCF) is defined as the Cash that is 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. There are three types of cash flows that a company’s statement of cash flow includes: 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 you can 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: 

Indirect Method

While using the Indirect method, net income is adjusted to a cash basis using the changes in non-cash accounts, like accounts receivable (AR), depreciation, and accounts payable (AP). Because many companies report the 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 through net income the revenue that was earned, 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.

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, it is necessary to know how much cash flow was generated in the period. Sometimes, we pay more attention to the fact of reading the financial statements about how many stages are present in the process of such calculations.

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 the expenses that have been incurred or accrued in the course of the period but have not necessarily been paid for with Cash or credit. Some examples of non-operational Cash 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.

There can be additional non-cash items and additional movements in current assets or current liabilities, which are different 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 all items are included in the checklist.

Operating Cash Flow VS Net Income 

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

Operating Cash Flow	Net Income
It is the cash which is generated via core operations of a company.	It is basically the profit which is earned with a period.
It works as a measurement of a company’s daily cash inflow and outflow about its operations.	Net income works as a starting point for calculating a company’s operating cash flow.
It works as a metric of a company’s ability to pay off its short-term debt.	It is an important step of a company’s profitability and a base of bond valuation and stock pricing.
Operating Cash Flow provides a more clear image of a company’s finances.	In net income, there is room to change the figures.
High operating cash flow shows a greater cash inflow than outflow.	A company that has a positive operating cash flow can have a negative net income.
OCF Formula = Net Income (+/-) Changes in Assets and Liabilities + Non-Cash Expenses	Net Income Formula = Total revenue – Total expenses

Operating Cash Flow VS Free Cash Flow 

OCF differs from FCF because while calculating FCF, one needs to deduct the capital expenditures. OCF and FCF are major indicators of organizational performance, which are normally used to establish whether the cash amount that an organization is generating 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 much as the earnings have been made after things like taxes, depreciation, and other operating costs have been taken into consideration.