Wajiha Danish | September 29 2023
Operating Cash Flow, often called cash flow from operating activities, is like a snapshot of a company’s financial health. It shows how much cash a company generates from its main business activities, like selling stuff, providing services, and paying its team. It’s the first thing you see on a cash flow statement.
Now, there are two ways to show this cash flow: indirect and direct. The indirect method adjusts the company’s net income on a cash basis. Net income includes some non-cash things like depreciation and accounts receivable. So, we use this formula to figure out OCF:
OCF = Net Income + Depreciation & Amortization – Change in Net Working Capital.
But we also need to account for changes in working capital on the company’s balance sheet. For example, if accounts receivable goes up, we earn money but still need the cash. So, we subtract that from net income. If accounts payable go up, we owe money, so we add it back to net income.
Imagine a company with a $100 million net income, $150 million in depreciation, a $50 million increase in accounts receivable, and a $50 million decrease in accounts payable. Its operating cash flow looks like this:
– Net Income: $100M
– Add back depreciation: $150M
– Subtract Increase in AR: $50M
– Subtract Decrease in AP: $50M
– Operating Cash Flow: $150M
Now, there’s also the direct method. Here, a company records all transactions on a cash basis. No adjustments are needed. It’s simpler but only covers cash in and out. So, the formula for OCF with the direct method is:
OCF = Cash Revenue – Cash Operating Expenses.
Financial experts like it because it shows the real picture of a company’s day-to-day money matters, free from accounting tricks. It’s a handy tool for understanding how well a business is doing.
Imagine you’re running a business. Making big sales might seem fantastic initially, but it won’t truly benefit your company if you’re struggling to collect the money. Conversely, you could raise cash from your day-to-day operations but report low profits if you own many fixed assets and use fancy depreciation calculations.
When a company needs to earn more from its main activities, it has to resort to temporary external funding sources like loans or investments. But there are more sustainable long-term solutions. That’s why we use a crucial figure called operating cash flow to gauge how financially stable a company’s operations are.
Operating cash flow isn’t the same as free cash flow (FCF), which is the money a company has left after covering its operations and other expenses. Both are used to check a company’s financial health.
The main difference is that FCF also considers capital expenditure. To calculate it, you subtract capital expenses from cash generated by operations:
FCF = cash from operations (CFO) — Capital Expenditures
Refrain from mixing up operating cash flow with net income, which is the difference between your sales revenue and all the costs like operating expenses, taxes, and more. When you calculate operating cash flow indirectly, net income is one of the initial pieces of the puzzle.
Both metrics help measure a company’s financial health, but the key difference lies in the timing of payments. If you’re getting paid late, there can be a big gap between net income and operating cash flow.
Cash flows come in three flavors: operating, investing, and financing. Operating cash flow covers all the money made from your company’s core activities. Investing cash flow tracks spending on assets and other business ventures. Lastly, financing cash flow includes money from debt, equity, and company payments.
Operating cash flow is like a financial health check for a company’s core business. It tells you how much cash your regular operations are bringing in. This figure is critical because it shows whether your company can generate enough cash to run and expand without external financing.
To calculate operating cash flow, you start with net income and adjust it to a cash basis. That means considering changes in non-cash accounts like depreciation, accounts receivable, and accounts payable. Since most companies report net income on an accrual basis, it includes non-cash items like depreciation and amortization.
Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital
EBIT stands for earnings before interest and taxes, sometimes called operating income. But it’s not the same as operating cash flow (OCF), the cash generated from your everyday business operations. The main distinction is that OCF includes interest and taxes as part of normal business operations.
The operating cash flow ratio shows how well a company can pay its debts with its current cash flow. You calculate it by dividing operating cash flow by current liabilities. If the ratio exceeds 1.0, the company is in a strong position to cover its debts without taking on more financial burdens.
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Wajiha is a Brampton-based CPA, CGA, and Controller with 17+ years of experience in the financial services industry. She holds a Bachelor of Science Degree in Applied Accounting from Oxford Brookes University and is a Chartered Certified Accountant. Wajiha spearheads Monily as its Director and is a leader who excels in helping teams achieve excellence. She talks about business financial health, innovative accounting, and all things finances.