:max_bytes(150000):strip_icc()/operatingcashflow-dd1426b405c34801b6780637498bc1c2.jpg)
Natalya Yashina is a CPA, DASM with over 12 years of experience in accounting including public accounting, financial reporting, and accounting policies.
Fact checked by Fact checked by Katrina MunichielloKatrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.
Operating cash flow (OCF) is cash generated by a company's normal business operations. It helps determine whether a company generates sufficient positive cash flow to maintain and grow its operations, without external financing. A company's statement of cash flows includes three types of cash flows: operating, investing, and financing.
Operating cash flows measure the 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, such as borrowing, buying capital equipment, and making dividend payments are excluded.
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 of the cash flow statement.
Operating cash flow provides a clear picture of the reality of the business operations. For example, a large sale boosts revenue, but if the company is having difficulty collecting the cash, the sale is not a true benefit for the company. On the other hand, a company may generate high amounts of operating cash flow but report low net income if it has a lot of fixed assets and uses accelerated depreciation calculations.
A company not bringing in enough money from core business operations may need to find temporary external funding through financing or investing. However, this is unsustainable in the long run. Operating cash flow helps assess the financial stability of a company's operations. The operating cash flow section can be presented under generally accepted accounting principles (GAAP) by the indirect or direct method. If the direct method is used, the company must still perform a separate reconciliation to the indirect method.
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.
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.
OCF = NI + D&A - NWC
Where:
Net income must 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 |
| Depreciation | Add back $150M |
| Increase in AR | Less $50M |
| Decrease in AP | Less $50M |
| Operating Cash Flow | $150M |
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:
This method is simpler than the indirect method with 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
Operating cash flow differs 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. FCF also accounts for capital expenditures, Free cash flow is calculated by:
FCF = Cash from operations (CFO) — Capital Expenditures
Operating cash flow differs from net income which is 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 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 difference between net income and operating cash flow.
Operating cash flow is a benchmark to determine the financial success of a company's core business activities as it measures the cash generated by normal business operations. Operating cash flow indicates whether a company has sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion.
The ratio is found by dividing cash from operations by the company's total liabilities to show the near-term liquidity risk of a company.
Operating cash flow helps determine the financial success of a company's core business activities and indicates whether a company has sufficient positive cash flow to maintain operations. Operating cash flow is one of three flows listed on a company's statement of cash flows, along with investing, and financing.
