How to Calculate Operating Cash Flow

It's the lifeblood of operations, indicating the cash generated or used by a company's core activities.

In this guide, we'll explore the intricacies of this vital financial metric, providing clear insights to help you confidently navigate its complexities and issues. Mastering operating cash flow is crucial for effective financial management and strategic decision-making; whether you're an experienced finance professional or an aspiring entrepreneur.

What Is Operating Cash Flow (OCF)?

Operating Cash Flow (OCF), often called cash flow from operations, is a fundamental financial metric used to assess a company's liquidity and financial health. Essentially, OCF represents the cash generated or consumed by a company's core operating activities:

• Revenue generation
• Production costs 
• Operating expenses

OCF excludes cash flows from investing and financing activities, focusing solely on the cash generated from day-to-day operations.

Positive OCF indicates that a company's core operations generate more cash than they consume, a sign of financial strength.

Conversely, negative OCF indicates that a company may struggle to generate sufficient cash from its operations to cover its expenses.

By tracking OCF over time, investors can monitor a company's cash generation trends and assess its financial stability. However, it's essential to interpret OCF alongside other financial metrics for a thorough analysis.

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How to Calculate Operating Cash Flow?

Operating cash flow can be determined using either the indirect or direct method, with their respective formulas. Both methods are commonly used in financial analysis.

Indirect Method

Calculating operating cash flow through the indirect method involves several steps:

1. Firstly, start with the net income figure from the income statement. 
2. Then, adjust for non-cash expenses such as depreciation and amortisation.
3. Next, account for changes in working capital, including adjustments for changes in accounts receivable, accounts payable, and inventory levels. 
4. Include any gains or losses on the sale of assets.
5. Subtract any interest and taxes paid to arrive at the operating cash flow figure.

The formula is:

Operating cash flow = (revenue – cost of sales) + depreciation – taxes +/- change in working capital

• Revenue refers to the earnings amassed by an organisation from sales within a particular accounting timeframe.
• The cost of sales is the expenditure for revenue generation during the accounting period.
• Depreciation reflects the decline in asset value over the accounting period.
• Taxes represent the financial amount an organisation pays for operations within its jurisdictions.
• Change in working capital indicates shifts in funds for producing and selling goods or services within an organisation.

Direct Method

Calculating operating cash flow using the Direct Method involves a straightforward approach to assessing a company's financial health.

1. First, identify all cash receipts from operating activities, such as cash received from customers or clients. 
2. Second, list all cash payments related to operating activities, including payments to suppliers, employees, and other operational expenses. 
3. Subtract the total cash payments from the total cash receipts to obtain the net cash generated from operating activities. 
4. It's crucial to exclude any non-operating cash flows, such as interest or investment income, from this calculation. 

The formula is:

Operating cash flow = total revenue - operating expenses

• Total revenue signifies the total earnings from sales within a specified accounting period.
• Operating expenses encompass the costs of running the organisation throughout the accounting period.

This method provides a clear, transparent view of how cash moves within the company's day-to-day operations, specifically related to operating activities. Regularly calculating operating cash flow aids in financial planning, decision-making, and assessing the company's ability to meet its short-term obligations.

Operating Cash Flow Calculation Examples

Suppose we need to calculate a company's operating cash flow (OCF) for a specific period using the following financial data.

• Net Income = $50 million
• Depreciation and Amortization (D&A) = $20 million
• Increase in Net Working Capital (NWC) = –$15 million

Indirect Method

Entering those assumptions into the OCF formula under the indirect method yields an illustrative company's OCF of $55 million.

Operating Cash Flow (OCF) = $50 million + $20 million – $15 million = $55 million

Put simply, the greater the gap between a company's operating cash flow (OCF) and reported net income, the more pronounced the impact of accrual accounting on its financial statements and operations.

Direct Method

Now, let’s calculate OCF using the direct method and the following data:

• Cash Receipts = $70 million
• Cash Payments to Suppliers = –$15 million
• Employee Wages = –$5 million

After inputting the above data into our OCF formula using the direct method, our company's OCF is $50 million.

Operating Cash Flow (OCF) = $70 million – $15 million – $5 million = $50 million

Why is Operating Cash Flow Important?

Operating cash flow is crucial for assessing a company's financial health and stability. It offers insight into liquidity by tracking cash flows tied to day-to-day operations.

Understanding operating cash flow aids investors in assessing a company's business model sustainability, identifying operational risks and opportunities, and comparing financial performance across industries.

It's a key metric for creditors and lenders when assessing creditworthiness. Skillful management of operating cash flow strengthens a company's resilience during economic challenges, guiding strategic decisions on capital allocation and resource management.

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Author: Giles Goodman, Commercial Intervention Officer OAR
Giles Goodman is the definitive expert in cross-border commercial debt collection, mediation, legal recovery, and accounts receivable. Based in London, his 25 years of experience provide a global perspective on preventing defaults and efficiently managing overdue accounts. Giles’s insights and analyses empower business owners worldwide with strategic approaches to financial management and recovery.

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