Operating Cash Flow (OCF): Definition, Cash Flow Statements (2024)

What Is Operating Cash Flow (OCF)?

Operating cash flow (OCF) is a measure of the amount of cash generated by a company's normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion.

Key Takeaways

  • Operating cash flow is an important benchmark to determine the financial success of a company's core business activities.
  • Operating cash flow is the first section depicted on a cash flow statement, which also includes cash from investing and financing activities.
  • There are two methods for depicting operating cash flow on a cash flow statement—the indirect method and the direct method.
  • The indirect method begins with net income from the income statement then adds back non-cash items to arrive at a cash basis figure.
  • The direct method tracks all transactions in a period on a cash basis and uses actual cash inflows and outflows on the cash flow statement.

Operating Cash Flow (OCF): Definition, Cash Flow Statements (1)

Understanding Operating Cash Flow (OCF)

Operating cash flow represents the cash impact of a company's net income (NI) from its primary business activities. Operating cash flow—also referred to as cash flow from operating activities—is the first section presented on the cash flow statement.

Two methods of presenting 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 must still perform a separate reconciliation to the indirect method.

Operating cash flows concentrate on cash inflows and outflows related to a company's main business activities, such as selling and purchasing inventory, providing services, and paying salaries. Any investing and financing transactions are excluded from the operating cash flows section and reported separately, such as borrowing, buying capital equipment, and making dividend payments. Operating cash flow can be found on a company's statement of cash flows, which is broken down into cash flows from operations, investing, and financing.

How to Calculate Operating Cash Flow

Indirect Method

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

The calculation for OCF using the indirect method uses the following formula:

OCF = NI + D&A - NWC

Where NI represents the company's net income, D&A represents depreciation and amortization, and NWC is the increase in net working capital.

Net income must also be adjusted for changes in working capital accounts on the company's balance sheet. For example, an increase in AR indicates that revenue was earned and reported in net income on an accrual basis although cash has not been received. This increase in AR must be subtracted from net income to find the true cash impact of the transactions.

Conversely, an increase in AP indicates that expenses were incurred and booked on an accrual basis that has not yet been paid. This increase in AP would need to be added back to net income to find the true cash impact.

Consider a manufacturing company that reports a net income of $100 million, while its operating cash flow is $150 million. The difference results from a depreciation expense 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 in this manner:

Net Income$100M
DepreciationAdd back $150M
Increase in ARLess $50M
Decrease in APLess $50M
Operating Cash Flow$150M

Direct Method

The second option is the direct method, in which a company records all transactions on a cash basis and displays the information using actual cash inflows and outflows during the accounting period. Examples of items included in the presentation of the direct method of operating cash flow include:

  • Salaries paid out to employees
  • Cash paid to vendors and suppliers
  • Cash collected from customers
  • Interest income and dividends received
  • Income tax paid and interest paid

This method is simpler than the indirect method because there are fewer factors to consider. However, it only accounts for cash revenues and expenses. It is calculated with the formula:

OCF = Cash Revenue — Operating Expenses Paid in Cash

Importance of Operating Cash Flow

Financial analysts sometimes prefer to look at cash flow metrics because they strip away certain accounting anomalies. Operating cash flow, specifically, provides a clearer picture of the current reality of the business operations.

For example, booking a large sale provides a big boost to revenue, but if the company is having a hard time collecting the cash, then it is not a true economic benefit for the company. On the other hand, a company may generate high amounts of operating cash flow but report a very low net income if it has a lot of fixed assets and uses accelerated depreciation calculations.

If a company is not bringing in enough money from its core business operations, it will need to find temporary sources of external funding through financing or investing. However, this is unsustainable in the long run. Therefore, operating cash flow is an important figure to assess the financial stability of a company's operations.

Operating Cash Flow vs. Free Cash Flow

Operating cash flow is different from free cash flow (FCF), the cash that a company generates after accounting for operations and other cash outflows. Both metrics are commonly used to assess the financial health of a firm.

The main difference is that FCF also accounts for capital expenditures, Free cash flow is calculated by:

FCF = Cash from operations (CFO) — Capital Expenditures

Operating Cash Flow vs. Net Income

Operating cash flow should also be distinguished from net income, representing the difference between sales revenue and the costs of goods, operating expenses, taxes, and other costs. When using the indirect method to calculate operating cash flow, net income is one of the initial variables.

While both metrics can be used to measure the financial health of a firm, the main difference between operating cash flow and net income is the time gap between sales and actual payments. If payments are delayed, there may be a large difference between net income and operating cash flow.

What Are the 3 Types of Cash Flows?

The three types of cash flow are operating, investing, and financing. Operating cash flow includes all cash generated by a company's main business activities. Investing cash flow includes all purchases of capital assets and investments in other business ventures. Financing cash flow includes all proceeds gained from issuing debt and equity as well as payments made by the company.

Why Is Operating Cash Flow Important?

Operating cash flow is an important benchmark to determine the financial success of a company's core business activities as it measures the amount of cash generated by a company's normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion.

How Do You Calculate Operating Cash Flow?

Using the indirect method, net income is adjusted to a cash basis using changes in non-cash accounts, such as depreciation, accounts receivable, and accounts payable (AP). Because most companies report the net income on an accrual basis, it includes various non-cash items, such as depreciation and amortization. Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital.

Is Operating Cash Flow the Same as EBIT?

EBIT is a financial term meaning earnings before interest and taxes, sometimes referred to as operating income. This is different from operating cash flow (OCF), the cash flow generated from the company's normal business operations. The main difference is that OCF also accounts for interest and taxes as part of a company's normal business operations.

What Is a Good Operating Cash Flow Ratio?

The operating cash flow ratio represents a company's ability to pay its debts with its existing cash flows. It is determined by dividing operating cash flow by current liabilities. A ratio greater than 1.0 indicates that a company is in a strong position to pay its debts without incurring additional liabilities.

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As a seasoned financial analyst with a background in accounting and cash flow management, my expertise lies in deciphering complex financial statements and understanding the intricacies of a company's financial operations. I've gained valuable insights through years of practical experience and continuous education in the field. Let's delve into the concepts presented in the article on Operating Cash Flow (OCF).

1. Operating Cash Flow (OCF) Overview:

  • OCF is a crucial metric that gauges a company's ability to generate positive cash flow from its core business activities.
  • It serves as a key indicator of financial success, signaling whether a company can sustain and expand its operations without relying on external financing.

2. Cash Flow Statement Structure:

  • OCF is the first section of a cash flow statement, which also includes cash from investing and financing activities.
  • The cash flow statement provides a comprehensive view of a company's cash inflows and outflows.

3. Two Methods for Depicting OCF:

  • Indirect Method: Starts with net income and adjusts for non-cash items to arrive at a cash basis figure.
  • Direct Method: Records all transactions on a cash basis, utilizing actual cash inflows and outflows during the accounting period.

4. Calculating Operating Cash Flow:

  • Indirect Method Formula: OCF = NI + D&A - NWC (Net Income + Depreciation and Amortization - Net Working Capital).

  • Adjustment for changes in working capital accounts, such as accounts receivable (AR) and accounts payable (AP).

  • Direct Method Formula: OCF = Cash Revenue — Operating Expenses Paid in Cash.

  • Direct method simplifies calculations by considering only cash revenues and expenses.

5. Importance of Operating Cash Flow:

  • Financial analysts prefer cash flow metrics, especially OCF, as they provide a clearer picture of a company's actual business operations.
  • OCF helps assess the financial stability of a company by revealing its ability to generate cash from core activities.

6. Operating Cash Flow vs. Free Cash Flow (FCF):

  • OCF differs from FCF, as FCF also considers capital expenditures (CapEx).
  • FCF = Cash from operations (CFO) — Capital Expenditures.

7. Operating Cash Flow vs. Net Income:

  • Net income represents sales revenue minus various costs and expenses, while OCF focuses on the cash impact of net income.
  • Time gap between sales and actual payments can lead to differences between net income and OCF.

8. Three Types of Cash Flows:

  • Operating Cash Flow: Generated from main business activities.
  • Investing Cash Flow: Involves capital assets and investments.
  • Financing Cash Flow: Includes proceeds from debt/equity issuance and payments made by the company.

9. Operating Cash Flow Ratio:

  • The operating cash flow ratio assesses a company's ability to pay debts with existing cash flows.
  • Calculated by dividing operating cash flow by current liabilities; a ratio above 1.0 indicates a strong position to pay debts.

10. OCF vs. EBIT:

  • EBIT (Earnings Before Interest and Taxes) is distinct from OCF, as EBIT focuses on earnings before interest and taxes, while OCF includes interest and taxes in normal business operations.

This comprehensive understanding of operating cash flow contributes to making informed financial decisions and evaluating a company's financial health.

Operating Cash Flow (OCF): Definition, Cash Flow Statements (2024)
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