3 min
28 September 2024
What is operating cash flow?
Operating cash flow (OCF) refers to the amount of cash generated by a company’s core business operations during a specific period. It excludes revenues from other sources such as investments and loans, focusing solely on the business's operational activities. OCF is a key indicator of a company’s financial health, revealing its ability to generate sufficient cash to maintain and grow operations without relying on external financing. It is calculated by adjusting net income for changes in non-cash net working capital items like depreciation, accounts receivable, and inventory. By analysing OCF, businesses can assess their ability to meet short-term obligations, reinvest in the business, and secure Bajaj Finserv Business Loan if needed. Understanding OCF is crucial for stakeholders to evaluate a company's operational efficiency and liquidity.Methods of operating cash flow
- Direct method: This method lists all cash receipts and payments made during the period. It includes cash received from customers, payments to suppliers, and other operational expenses. The direct method provides a clear view of cash inflows and outflows directly related to operating activities.
- Indirect method: The indirect method starts with net income and adjusts for changes in net working capital and non-cash items like depreciation and amortisation. This method is commonly used as it is easier to prepare using information already reported on the income statement and balance sheet.
- Adjusted net income method: Similar to the indirect method, this approach begins with net income but makes adjustments for operating activities only, ignoring non-operating items such as interest and taxes. This method provides a purer view of cash flows directly related to operational activities.
Operating cash flow example
- Net income calculation: Assume that a company has a net income of ₹10,00,000 for a fiscal year.
- Adjustments for non-cash items: Add back non-cash expenses like depreciation of ₹2,00,000 and amortisation of ₹50,000 to the net income.
- Changes in working capital: Adjust for changes in net working capital, such as an increase in accounts receivable by ₹1,00,000 and a decrease in inventory by ₹1,50,000.
- Calculate OCF: The operating cash flow will be ₹10,00,000 (net income) + ₹2,00,000 (depreciation) + ₹50,000 (amortisation) - ₹1,00,000 (increase in accounts receivable) + ₹1,50,000 (decrease in inventory) = ₹13,00,000.
Significance of operating cash flow
- Liquidity assessment: Operating cash flow indicates a company’s ability to generate cash from its core activities, which is crucial for maintaining liquidity and covering short-term obligations.
- Investment potential: A strong OCF enables a business to reinvest in its growth without relying on external financing, making it more attractive to investors.
- Debt management: Companies with consistent OCF can easily manage debt repayments and are often better positioned to secure a business loan with favourable terms.
- Operational efficiency: Analysing OCF helps in assessing the efficiency of a company’s operations, ensuring that the business is not overly reliant on non-operational income for cash generation.
Operating cash flow formula
- Net income: Begin with the net income, which is the profit after all expenses, including taxes and interest, have been deducted.
- Add back non-cash expenses: Include non-cash expenses such as depreciation and amortisation, as these do not involve actual cash outflows.
- Adjust for changes in working capital: Incorporate changes in net working capital components, like accounts receivable, inventory, and accounts payable.
- Final formula: OCF = Net Income + Non-Cash Expenses + Changes in Working Capital. This formula provides a clear picture of the cash flow generated from the core business activities.
Operating cash flow vs Net income
- Definition: Net income is the profit after all expenses, including taxes, have been deducted from total revenue. OCF, on the other hand, reflects the cash generated from operating activities, excluding non-cash items.
- Focus: While net income includes all sources of revenue and expenses, OCF focuses only on the cash flow from core business activities, making it a better indicator of operational health.
- Timing: Net income can be influenced by accounting practices, such as recognising revenue and expenses, while OCF shows the actual cash inflows and outflows, offering a more immediate picture of a company’s financial situation.
- Utility: Investors and analysts often prefer OCF over net income to evaluate a company’s liquidity and ability to sustain operations without external financing.
Operating cash flow formula vs Free cash flow formula
- OCF formula: The OCF formula focuses on cash generated from core operations, calculated as Net Income + Non-Cash Expenses + Changes in Working Capital.
- Free cash flow (FCF) formula: FCF goes further by deducting capital expenditures (capex) from the OCF. The formula is FCF = OCF - Capex.
- Purpose: OCF provides insight into the cash flow generated from operating activities, while FCF indicates the cash available after investments in long-term assets, making it crucial for assessing a company’s ability to fund growth and pay dividends.
- Investment decisions: Companies with high OCF but low FCF may be heavily investing in capex, impacting their ability to distribute cash to shareholders or reinvest in other growth opportunities.
