Operating Cash Flow

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21 Aug, 2024

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Operating cash flow (OCF) refers to the net amount of liquidity a company generates through its operational activities without including any financing or investing activities operations. The purpose of operating cash flow is to provide a clear and concise measure of a company's ability to generate cash from its core business operations.

It has more credibility over net income regarding ascertaining a company's financial health. By comparing it with the requirements of purchasing fixed assets, one can get a fair idea of a company's cash flow to manage its capital base. Generally, it gets used together with net income and other metrics during the financial analysis of a company.

What Is Operating Cash Flow?

Operating cash flow is when a company excludes financing and investment activities, from the total liquidity it generates through its daily business operations.
Analysts need crucial corporate information to assess the viability of a company's core activities since a positive value denotes a firm's operations as healthy and expanding.
OCF measures the cash created by an organization via its operational operations, whereas free cash flow measures the cash it must release to its shareholders. EBITDA does not include tax or interest into account when calculating cash creation.

Operating Cash Flow Explained

Operating cash flow is a company's total cash through its usual operating activities within a particular duration. It also gets used in measuring the net cash flow brought about by the primary operations of a business. Moreover, it provides insight into how much cash a company is generating from its day-to-day operations, excluding cash flows from financing and investing activities.

Furthermore, it shows whether a company invests too much in repairing machinery and has more extended production downtime. Hence, net operating cash flow is a crucial financial metric that helps stakeholders understand the cash flow dynamics of a company's core business operations. Besides, operational cash flow activities are reported in the statement of cash flows and are essential for assessing a company's ability to generate cash from its primary functioning.

There are two methods of determining this cash flow for a company:

#1 - Direct Method

One can take it as the simplest method of accurately calculating this cash flow. Hence, the result from the calculation is only beneficial to the company for knowing its operational performance. However, investors only get a few detailed insights into the financial position of a business using it. The most straightforward operating cash flow formula is:

Operating cash flow = Cash Revenue – Operating Expenses

#2 - Indirect Method

Here, the net income gets adjusted by adding non-cash elements into the account for appropriate changes in the balance sheet. Moreover, the changes in cash receivables plus the inventor get adjusted in the account by adding depreciation. Simply put, the non-cash elements get added to the net income and level out the net capital variation. Therefore, its formula can be represented as:

Operating cash flow = Net income + Depreciation &Amortization- Increase in net working capital

Examples

Let us use a few examples to understand the topic.

Example #1

Let’s say Chevron Limited Co. has reported its opening cash flow with the help of the indirect method. Its net income is reported as $200,000, depreciation as $10,000, and changes in working capital is $30,000. Therefore, its operating cash flow is calculated as:

Operating cash flow = NI +D&A-NWC

= $200,000 + $10,000 - $30,000

= OCF = $180,000

In this example, "Chevron Inc." has an operating cash flow of $180,000. This means that after considering non-cash items (depreciation and amortization) and changes in working capital, the company's core business operations generated a net cash flow of $180,000 during the specified period.

Example #2

Let's calculate the cash flow using the direct method for Citigroup Company based on the following information for a specific period.

Cash received from customers (Cash Revenue)= $200,000

Cash paid to suppliers for goods or services (Operating Expenses)= $80,000.

Therefore, its operating cash flow is calculated as:

Cash Revenue - Operating expenses

= $200,000 - $80,000

= $120,000

In this example, Citigroup has an operating cash flow of $120,000 using the direct method. This means the company's core business operations generated a net cash flow of $120,000 during the specified period, based on the actual cash inflows and outflows related to operating activities.

Importance

Let us discuss some of the importance of this cash flow:

Financial Health Indicator: It is a fundamental measure of a company's financial health, showing how well it can generate cash from its core business operations.
Sustainability: Positive OCF indicates that the company's operations can sustain itself and meet ongoing expenses without relying heavily on external funding.
Cash Flow Management: These helps in effective cash flow management, ensuring the company has enough cash to cover short-term obligations and avoid liquidity issues.
Investment Decision-Making: Investors consider it to evaluate a company's cash-generating ability and potential for sustainable growth.
Comparing Companies: They allow for meaningful comparisons between companies within the same industry, helping identify operational efficiency.
Financial Forecasting: This data is used for forecasting, budgeting, resource allocation, and setting financial goals.
Performance Measurement: It serves as a key performance indicator, reflecting how well a company's core business activities contribute to its financial success.
Supports Growth Initiatives: Positive cash flow provides the financial foundation for funding growth initiatives and capital expenditures.
Creditor Confidence: Lenders and creditors use this to evaluate a company's ability to meet its debt obligations.

Operating Cash Flow vs Free Cash Flow vs EBITDA

Let's use a table to understand the difference between operating cash flow, free cash flow, and EBITDA.

Operating Cash Flow	Free Cash Flow	EBITDA
It measures all cash generated by a firm using its operational activities.	Free cash flow is the cash a firm must distribute to the owners.	EBITDA does not incorporate tax or interest factors while calculating cash generation.
This cash flow informs investors of the viability of a firm’s financial health.	After subtracting all capital expenditure from OCF, one gets it.	Helpful in comparing more than two companies in terms of profitability.
Moreover, it measures the total cash available to a firm to fund its daily business activities.	This cash flow represents the cash available to the company for making new investments, paying dividends, or buying back shares.	These are most commonly used in credit agreements covenants formulation.
Hence, it only helps one to know how much cash gets generated from a company's business operations.	Hence, it only helps one to know how much cash is generated from a company's business operations.	Overall, it works well only with the help of other financial metrics.

Frequently Asked Questions (FAQs)

1. What is the operating cash flow margin?

Operating cash flow margin is a financial ratio measuring the percentage of a company's revenue converted into this cash flow. It provides insights into how efficiently a company's core business operations generate cash relative to its total revenue.

2. When does operating cash flow increase?

Several factors can contribute to an increase in operating cash flow:
- Higher sales revenue
- Cost management
- Improved profit margins
- Effective inventory management
- Optimizing working capital
- Quick collections of account receivables

3. What does positive/negative operating cash flow indicate?

Positive operating cash flow indicates that the company's core business operations generate more cash than spending, generally a positive sign of financial health. Negative OCF suggests that the company's core operations consume more cash than it generates, raising concerns about economic sustainability.