Operating cash flow : 4 things to know

What is operating cash flow?

Operating cash flow, or “OCF” as it is often referred to, is the net cash a company generates from its regular business activities. These activities usually involve manufacturing goods and selling them or providing services to clients. The income from operations is usually the first section reporting in a company’s cash flow statement.

Income from these activities excludes any income from investment or financing, which appear separately in a company’s financial statements in the form of “cash flow from investments” and “cash flow from financing”.

A company’s operating cash flow reflects the actual inflow and outflow of cash and cash equivalents over a specified period of time.

OCF can be either positive or negative. It is positive when there is enough income from operating activities to cover the company’s needs in terms of working capital and capital expenditures (CapEx). When a company has positive OCF, it will have enough income to cover liabilities and invest in additional growth. Positive OCF puts a business on a strong footing, bolsters confidence among investors and stakeholders and indicates the business is thriving. It may open up the possibility of reducing outstanding debts, rewarding performance or launch a new product or service.

When a company has negative OCF, this means it does not generate enough from its operating activities to cover its liabilities. In this situation, it needs to either seek additional funding (investments, loans) to cover its requirements or it will not break even and may find it difficult to pay suppliers or employees.

How is operating cash flow calculated?

Operating cash flow is monitoring closely by financial analysts, investors and funders, as it can provide critical insights into the financial stability of the business. There are two main ways of calculating operating cash flow: the indirect method and the direct method.

Direct method

The direct method involves cash-basis accounting to take a direct look at the cash implications of financial transactions. This method only takes into account cash revenue and cash operating expenses. In other words, operating cash flow is calculated by adding cash generated from selling goods or services to customers and cash generated from interest and dividends and then subtracting cash paid out to suppliers, wages paid to employees, income taxes paid, etc.

The formula for calculating operating cash flow using the direct method is:

Operating cash flow = cash revenue – operating expenses paid in cash.

Indirect method

The indirect method of calculating operating cash flow starts with the net income of the business and adjusts this by subtracting non-cash expenses such as those relating to depreciation, amortisation, income taxes, and finance-related income and expenses. Adjustments are also made for changes in net working capital. 

The formula for calculating operating cash flow using the indirect method is:

Operating cash flow = net income + depreciation & amortisation – increase in net working capital.

As with many financial modelling and analysis methods, however, many other variables may also need to be taken into account, including certain non-cash items and other additional assets and liabilities. In many cases, it may be useful to turn to a financial expert to get an accurate operating cash flow figure, leaving you free to concentrate on what to do with the information it provides.

Operating cash flow ratio

Once the OCF has been calculated, the operating cash flow ratio is used to determine whether the operating cash flow is sufficient to cover the company’s current liabilities. The formula used for the operating cash flow ration is:

Operating cash flow ratio = operating cash flow / current liabilities

Current liabilities are those debts which are due to be repaid within a year. The operating cash flow ratio is a liquidity ratio which measures how easily a company could settle its current liabilities with its operational cash flow resulting from its business activities. It is considered to be a useful measure of how well a company is performing in the short term.

Example

The operating cash flow ratio of a company can be calculated if both the operating cash flow and current liabilities are known. 

The operating cash flow ratio of a company with an operating cash flow of £200,000 and current liabilities of £90,000 would be calculated as follows:

Operating cash flow ratio = £200,000 / £90,000 = 2.22

This means that for every pound of liability the company owes, it makes £2.22 from its operating activities. In other words, this company has a positive operating cash flow ratio and could repay its current liabilities 2.22 times over. A healthy company, in other words!

How to use operating cash flow ratio

The operating cash flow ratio indicates whether the company is financial stable and in a position to cover its debts. In the example above, the company’s operation cash flow ratio was good, and shareholders would feel reassured that their investments were safe for the time being.

A company with a negative operating cash flow ratio, on the other hand, would illustrate a company in difficulty, at least in the short term, and might raise concerns among shareholders and investors as to what the company intended to do to resolve the issue. Short periods with a negative OCF ratio are not unusual, however, and may simply indicate a need for greater investment to generate healthier cash flows.

Conclusion

Tracking operational cash flows and monitoring and analysing operational cash flow ratios are essential for business owners, investors and shareholders to be able to drill down into a company’s financial performance.

Good bookkeeping and accounting practices allow owners to track these key indicators closely, identifying weaknesses and seizing opportunities. Incorporating flexible financial management solutions can give business owners the confidence to make decisions based on reliable, accurate figures. Find out what Mooncard can do for your business by booking a no-obligations demonstration of our products today!