Operating Cash Flow

Operating Cash Flow (OCF) is a key financial metric that measures the cash generated or used by a company’s core business activities during a specific period. It reflects the actual cash inflows and outflows from day-to-day operations, excluding any cash flows from investments or financing activities.

It’s a critical indicator of a company’s ability to maintain and grow its operations without needing external financing or selling long-term assets.

OCF is found on the cash flow statement and differs from net income (profit) because it excludes non-cash expenses like depreciation and changes in working capital (e.g., accounts receivable, inventory, and accounts payable).

Calculating OCF

There are two main methods to calculate OCF:

Direct Method: This method lists all cash transactions related to operations, such as:

Cash Received from Customers − Cash Paid for Operating Expenses

This is the straightforward approach, but many companies prefer the indirect method.

Indirect Method: This method starts with net income and adjusts for non-cash items and changes in working capital. The formula is:

OCF (Indirect) = Net Income + Non-Cash Expenses + Changes in Working

Adjustments include adding back depreciation and amortisation (non-cash expenses) and factoring in changes in accounts receivable, inventory, and accounts payable.

Importance of OCF

• Shows Cash Generation Ability.

OCF highlights cash generated from core operations. This is crucial for sustaining business activities. Can it cover its expenses? Reinvest in growth? Or pay dividends without relying on external financing?

• Differs from Profit.

Profit (net income) includes non-cash items, so it can be misleading. A company may report a profit but still struggle with liquidity if OCF is weak. OCF gives a clearer picture of actual cash health.

• Liquidity and Financial Health.

Can a company can meet its short-term obligations, like paying suppliers and employees? Positive OCF means the business is self-sustaining. A negative OCF may signal liquidity problems.

• Valuation and Investment Decisions.

Investors and analysts often prefer OCF to net income for valuing companies because it’s harder to manipulate through accounting practices. A company with consistently strong OCF is seen as financially stable.

Benefits of OCF

Provides a Clear Picture of Cash Operations. Unlike net income, OCF strips away non-cash items, giving a real picture of how much cash is being generated from the company’s core operations.

Indicator of Financial Stability. Positive OCF indicates that a company’s operations are healthy and capable of sustaining the business without needing external financing.

Helps in Business Planning. Understanding OCF helps companies plan their budgets, investments, and financing needs based on real cash available from operations.

Drawbacks of OCF

Can Be Volatile. OCF can fluctuate significantly due to changes in working capital. For instance, if a company delays paying its suppliers, OCF will look higher, even though the company still has liabilities.

Doesn’t Show Full Financial Picture. While OCF shows cash generation from operations, it doesn’t provide insight into how much is being spent on investments or how the business is being financed. Therefore, it should be considered alongside other metrics.

Short-Term Focus. Relying too heavily on OCF could lead to a short-term focus, encouraging management to delay necessary expenses (like inventory purchases or paying suppliers) to boost OCF in the short term.