What’s Operational Cash Flow (OCF)?
A company’s typical business operations create a certain amount of cash, which is measured by its operating cash flow (OCF). If a business cannot produce enough positive cash flow to sustain and expand its operations, it may need to seek outside funding for capital expansion. This is what operating cash flow shows.
KEY TAKEAWAYS:
• Operating cash flow is a crucial metric for assessing the financial performance of an organization’s main business operations.
• Cash from investment and financing activities is included in the first section of a cash flow statement, which is operating cash flow.
• The indirect technique and the direct method are the two ways operating cash flow can be shown on a cash flow statement.
• To calculate the cash basis number, the indirect method starts with the income statement’s net income and adds back non-cash items.
• The direct technique uses actual cash inflows and outflows on the cash flow statement and tracks all transactions in a period on a cash basis.
Gaining Knowledge of Operating Cash Flow (OCF) :
Gaining Knowledge of Operating Cash Flow (OCF)
The cash effect of a business’s net income (NI) from its main operations is represented by its operating cash flow. The cash flow statement’s first section is called operating cash flow, sometimes known as cash flow from operating operations.
Generally accepted accounting rules (GAAP) permit the presentation of the operating cash flow section in one of two ways: either directly or indirectly. Even so, the business needs to carry out a separate reconciliation to the indirect way if the direct approach is utilized.12
Operating cash flows focus on the inflows and outflows of cash associated with a business’s primary operations, which include paying salaries, offering services, and buying and selling inventory. Investing and financing activities, such as borrowing, purchasing capital equipment, and paying dividends, are not included in the operating cash flows section and are reported separately. The statement of cash flows of a business, which is divided into cash flows from operations, investing, and financing, contains operating cash flow information.
How the Indirect Method of Operating Cash Flow Calculation Works
Through the use of changes in non-cash accounts like depreciation, accounts receivable (AR), and accounts payable (AP), net income is adjusted to a cash basis utilizing the indirect method. Due to the accrual method used by most businesses to record net income, it includes a number of non-cash factors such amortization and depreciation.
The following formula is used in the indirect approach computation of OCF:
NI + D&A – NWC = OCF
where D&A stands for depreciation and amortization, NWC for the increase in net working capital, and NI stands for the net income of the business.
On the balance sheet of the business, net income must also be adjusted for changes in the working capital accounts. In spite of the fact that cash has not yet been received, an increase in AR, for instance, shows that revenue was produced and recorded in net income on an accrual basis. To determine the actual cash impact of the transactions, net income must be deducted from this increase in AR.
An increase in AP, on the other hand, denotes unpaid expenses that were incurred and recorded on an accrual basis. To determine the net revenue, this rise in AP would need to be added back.
Let us examine a manufacturing company with an operating cash flow of $150 million and a reported net income of $100 million. Depreciation costs of $150 million, a $50 million rise in accounts receivable, and a $50 million drop in accounts payable account for the discrepancy. This is how it would show up on the cash flow statement’s operating cash flow section:
$100 million in net income
Devaluation Refund $150 million.
Growth in AR Less $50 million
Reduced AP Less $50 million
operating cash flow $150 million
Direct Approach
The second choice is the direct method, wherein a business keeps a cash record of every transaction and uses the real cash inflows and outflows for the accounting period to show the information. The following are some instances of elements that are presented in the direct way of operating cash flow presentation: employee salaries; cash paid to suppliers and vendors; cash received from customers; interest income and dividends received; income tax paid; and interest paid.
There are fewer aspects to take into account with this strategy than with the indirect method, making it simpler. It does, however, solely take cash receipts and outlays into account. The formula is used to compute it:
OCF = Cash Revenue — Operating Expenses Paid in Cash
Why Operating Cash Flow Is Important
Cash flow measures can be a preferred choice for financial analysts since they can eliminate some accounting irregularities. In particular, operating cash flow gives a better sense of the state of the business’s activities right now.
For instance, securing a sizable sale boosts revenue significantly, but it is not a meaningful economic benefit for the business if it is suffering with cash collection. On the other hand, if a business has a large number of fixed assets and employs accelerated depreciation estimates, it may produce large levels of operating cash flow but report a relatively low net income.
A corporation must locate short-term external cash sources through financing or investment if its main business operations are not producing enough revenue. On the other hand, this is not long-term viable. Because of this, operating cash flow is a crucial metric for evaluating the operational financial soundness of a business.
Comparing Operating and Free Cash Flow
Operating cash flow is distinct from free cash flow (FCF), which is the amount of money left over after expenses for operations and other outflows are deducted. A firm’s financial health is often evaluated using both of these indicators.
The primary distinction is that capital expenditures are also taken into account by FCF. Free cash flow is computed as follows:
FCF is equal to Capital Expenditures — Cash from Operations (CFO).
Operating Cash Flow vs. Net Income
Operating cash flow, which shows the difference between sales revenue and the costs of goods, operating expenses, taxes, and other costs, should also be distinguished from net income. Net income is one of the first factors when calculating operating cash flow using the indirect approach.
The distinction between operating cash flow and net income is mostly the amount of time that passes between sales and actual payments, even though both measures can be used to assess a company’s financial health. There might be a significant discrepancy between operating cash flow and net profits if payments are delayed.
Q. What Kinds of Cash Flows Are There?
There are three different forms of cash flow: financing, investing, and operating. All cash produced by a company’s primary business operations is included in operating cash flow. All capital asset purchases and investments in other company endeavors are included in the term “investing cash flow.” All proceeds from the issuance of debt and stock, as well as corporate payments, are included in the financing of cash flow.
Q. Operating Cash Flow: Why Is It Important?
Operating cash flow, which gauges the quantity of money produced by a company’s regular business operations, is a crucial metric for assessing the financial performance of a company’s fundamental business activities. If a business cannot produce enough positive cash flow to sustain and expand its operations, it may need to seek outside funding for capital expansion. This is what operating cash flow shows.
Q .How Is Operating Cash Flow Calculated?
By making adjustments to non-cash items like depreciation, accounts receivable, and accounts payable (AP), net income is converted to a cash basis utilizing the indirect method. Due to the accrual method used by most businesses to record net income, it includes a number of non-cash factors such amortization and depreciation. Operating Cash Flow is calculated as follows: Operating Income + Depreciation + Taxes + Working Capital Change.
Q .Is EBIT and Operating Cash Flow the Same?
Earnings before interest and taxes, often known as operating income, is referred to in finance as EBIT. This is not to be confused with operating cash flow (OCF), which is the cash flow that results from regular business operations for the company. The primary distinction is that OCF includes accounting for taxes and interest as a regular component of a business’s operations.
Q .Which Operational Cash Flow Ratio Is Best?
The operating cash flow ratio shows how much of a company’s current cash flows can be used to pay off debt. The calculation involves dividing the operating cash flow by the current liabilities. A corporation is in a strong position to pay off its debts without taking on new obligations if its ratio is greater than 1.0.
