Operating cash flow (OCF) measures the amount of cash generated by the normal operating activities of a business. It is calculated using the formula net income plus non-cash items such as depreciation and amortization, less changes in working capital.
Not to be confused with free cash flow, your business's OCF is an essential metric for measuring financial health because it indicates how much cash a company is generating from its ongoing operations. Therefore, it is a key indicator of the company's financial health and should be viewed as a vital feature of the company's cash flow statement.
This is highlighted by the fact that having a positive operating cash flow gives businesses the liquidity to cover their short-term obligations, pay dividends to shareholders, and reinvest in their growth.
If you want a clearer picture of your company's earnings, then learning how to calculate your OCF with an operating cash flow formula is an excellent way to start. By the end of this article, you'll know how to calculate operating cash flow and understand its essential role in tracking and securing your company's financial performance.
What is an operating cash flow ratio?
Your business's OCF ratio is the ratio of your operating cash flow to your total liabilities. Essentially, it measures how efficiently you generate and manage cash relative to the size of your liabilities to determine whether the company's normal business operations are generating more cash than is needed to survive.
A higher OCF ratio indicates that a company can cover more of its financial obligations with current earnings, which suggests greater financial stability.
This information has a wide variety of uses, such as helping investors and creditors better understand a company's financial position or aiding internal decision-making about potential investments. Crucially, it makes better sense of the company's operating cash flow because it accounts for both cash inflows and cash outflow.
For example, if you plan on a significant expansion or acquisition, you need to ensure you have the cash available to fund it. By looking at your operating cash flow ratio, you can better understand how feasible your plan is.
Operating cash flow OCF is also a good measurement of how well your accounts receivable process is working. Your operating cash flow will suffer if you're having difficulty collecting payments, and it's a good indication that you might need to make some changes to how you approach accounts receivable and credit control.
Who benefits from having the operating cash flow calculations shown on the cash flow statement?
OCF is a noteworthy metric for several parties who may need to analyze the company's cash flow and ability to generate profit exclusively through standard business operations. They include;
- In-house analysts because the OCF figure, as well as the actual cash inflows and cash outflows, highlight the company's financial status. It helps analysts review the sustainability of the company's profitability within the given period and subsequently supports future decisions.
- Prospective lenders because they need to know whether they are likely to get their money back from the borrower. Clear evidence of profits made directly from the core business operations inevitably allows them to lend money with greater confidence of seeing an ROI themselves.
- Investors because they want to focus on investing and financing activities for businesses that can grow and deliver a healthy ROI. When OCF calculations show that normal business operations have delivered a profit, it shows that the company has a good platform to build upon.
Ultimately, anybody who wants to gain a better insight into the company's cash flows and core business activities will benefit from seeing the business's OCF.
Calculating OCF: A step-by-step guide to using an operating cash flow formula
Now that you've got a better idea of what your operating cash flow is and how it can be used, let's look at exactly how you calculate your OCF cash flows.
There are two methods to calculate cash flow with a focus on OCF; direct and indirect. They are detailed below:
The indirect method
The indirect method for calculating your operating cash flow is the more commonly used approach and essentially works by subtracting non-cash expenses from net income.
So, to calculate operating cash flow OCF with the indirect formula, you will need to follow these steps:
- Calculate your company's total net income (this is the bottom line on your income statement)
- Subtract any taxes owed from net income
- Add back in non-cash expenses such as depreciation and amortization on fixed assets
- Calculate changes in working capital (this is the difference between current assets and current liabilities on your balance sheet)
- Subtract the change in working capital from the sum of net income and non-cash expenses
The result is your operating cash flow from operating activities.
The formula for calculating your OCF using the direct method looks like this:
OCF = net income + depreciation and amortization - net working capital
While the indirect method of calculating OCF is more complicated and time-consuming than the direct method, it provides a more accurate picture of your business's cash flow.
Taking account of accounts receivable and accounts payable
One of the critical variables associated with using the indirect method is the impact your A/R and A/P have on your net income.
For example, an increase in A/R will reduce your net income, even though you haven't actually received the money yet.
The same is true for accounts payable, where an increase in A/P will increase your net income, even though you haven't actually paid out any cash.
To account for this effect, you need to adjust your indirect operating cash flow calculation to include any changes in your A/R and A/P.
The direct method
The direct method of calculating operating cash flow considers the actual inflows and outflows of cash from a company's operations. Examples of these inflows and outflows include:
Cash inflow:
- Cash sales
- A/R collections
- Loan proceeds
Cash outflow:
- Salaries for staff
- Payments to suppliers
- Interest expenses
- Debt repayments
- Dividends paid to shareholders
The formula for using the direct method looks like this:
OCF = Cash received from operations - Cash paid for operations
As you can see, the direct method is far simpler than the indirect method. However, it does not provide comprehensive results and can miss important cash flow issues that the indirect method would pick up.
OCF calculation examples
Now that you know how to calculate OCF using different operating cash flow formula options, let's examine two examples demonstrating the process and how they calculate the figures that show in a company's financial statements.
Example 1: Using the direct method
Let's say your company has $200,000 in cash sales and receives $20,000 from A/R collections during a given month. During the same period, you pay out $180,000 in salaries and $20,000 for supplies.
Your OCF (using the direct method) would be:
OCF = $200,000 + $20,000 - $180,000 -$20,000 = $20,000
Example 2: Using the indirect method
Let's say your company has a net income of $200,000 and depreciation expenses of $20,000. You also have an increase in accounts receivable from $180,000 to $200,000.
Your operating cash flow (using the indirect method) would be:
OCF = $200,000 + $20,000 - ($200,000 - $180,000) = $220,000
Operating cash flow OCF FAQ
Because operating cash flow is similar to other metrics such as net income, free cash flow (FCF), and earnings before interest and taxes (EBIT), but with a few critical differences, it can be difficult to understand the differences between them.
However, it's important to understand the role of operating cash flow OCF, free cash flow, and net cash flow within the cash flow statement. The following FAQs should provide further insights into OCF and its interactions with other cash flow calculations.
Q: What is a good operating cash flow ratio?
A: There is no universal answer to this question, as it depends on your industry and the type of business you are running. Generally speaking, a positive number is good and will go a long way to creating a positive overall net cash flow for the company. Still, desired OCF cash flow ratios will vary depending on the situation.
Q: Is operating cash flow OCF the same as net income?
A: No, they are not the same. While net income indicates profitability, operating cash flow measures a company's ability to generate cash from its operations. Therefore, you will want to calculate OCF alongside using the net income and net cash flow formula rather than as a direct replacement.
Q: How does operating cash flow differ from free cash flow?
A: Operating cash flow and free cash flow measure different aspects of your business's financial performance. OCF measures the amount of cash a company generates from its core operations, while free cash flow measures this while taking capital investments and financing activities into account. For the most accurate look at the company's financial health, it is important to calculate free cash flow using the free cash flow formula while also calculating OCF separately.
Q: Is operating cash flow the same as EBIT?
A: No, EBIT is a measure of profitability, while operating cash flow measures the amount of cash generated from operations. EBIT is calculated by subtracting operating expenses from revenue while operating cash flow is calculated by subtracting operating expenses from net income.
Q: What other metrics should I be tracking in addition to operating cash flow?
A: It depends on your business, but some other important metrics to track include gross margin, net income, and working capital. Keeping track of these metrics will help you get a better understanding of your business's financial health. Meanwhile, net cash flow also takes interest, taxes, depreciation, and amortization into account.
Keeping up to date with your operating cash flows
Understanding and calculating operating cash flow OCF is an essential part of managing the finances of your business and should feature in all cash flow statements. By following the steps outlined above, you can accurately measure how much cash is being generated by your operations and make informed decisions about how to allocate resources.
With the right information regarding cash inflows and cash outflow courtesy of the OCF's insight into the company's core business activities, you can make sure that your business is running smoothly and efficiently!
One of the best ways to improve your operating cash flow is to reduce the number of outstanding invoices and accounts payable. It's vital to be proactive in collecting what you are owed so that your cash flow doesn't suffer as a result of delayed payments or unpaid invoices.
Payment reminder automation is a proven way to speed up payments and improve cash flow. Automating payment reminders can save you time, reduce the likelihood of unpaid invoices, and help keep your business's operating cash flow in the black.
To find out how Chaser's automated payment reminders can improve your operating cash flow OCF and get paid faster, book a free demo today or start your free no-obligation 14-day trial.
