Every business requires a measurement that can estimate a company’s operational growth. It also helps the investor or creditors to foresee if a company is making enough money to maintain its primary activities and growth of a company. This idea of the calculation is essential to forecast the financial status and health of a company.
Operating Cash Flow Definition
Operating Cash Flow (OCF), is a calculation that estimates cash generated from the principal operation and activities and then deducting operating expenses from actual revenue. The calculation is used to understand how much money a business is making without considering the secondary sources, such as investment, interest to maintain and grow its operation. It is also known as cash flow from operations.
Apart from the annual cash flow statement and quarterly financial reports, public companies as per the Generally Accepted Accounting Principles (GAAP) are obliged to measure operating cash flow utilising an indirect method. This measurement is done by adjusting net income to accrual basis that includes non-cash accounts, such as accounts receivable, changes in inventory, and Depreciation.
The operating cash flows focus on cash inflows and outflows associated with the company’s main operation activities. These activities include paying salaries, selling and buying inventory, and providing services.
While reporting OCF, all investments and financial transactions are excluded and reported separately. Operating cash flow is recorded on a company’s cash flow statement, which divides into cash flows from investing, financing, and operations.
Operating Cash Flow Formula
There are two different ways of calculating OCF.
- The Direct method
- The In-direct method
1. Direct method
Operating Cash Flow = Total Revenue – Operating Expense
This formula is precise and straightforward but does not provide enough information about the organisation, its operation, and the source of cash. Therefore, GAAP insists companies to apply the indirect method to measure the cash flows from operations.
2. In-direct method
Operating Cash Flow = Net Income +/- Changes in Assets and Liabilities + Non-Cash Expenses
In the Indirect method, OCF adjusts net income to cash basis using changes in all non-cash accounts on the balance sheet. Amortisation and Depreciation are added to net income when the adjustments are made in accounts receivable and inventory.
Importance of Operating Cash Flow
Operating cash flow is an essential part of a cash flow statement as it gives a transparent financial view of the current business operations.
For example, if a company seals a large sale deal, it will boost its revenue. However, if the company is not able to collect the money, then it is not positively affecting its economy. Similarly, a company generates high OCF, but the net income is low because of high fixed assets and practices accelerated depreciation calculations.
Operating Cash Flow Calculation Example
Radha’s music shop specializes in guitars and other musical instruments. Radha’s competitor is Geeta Center, and she wants to examine the way she improves her business. Radha’s financial statements for the financial year is given below:
- Net income: ₹1,00,000
- Depreciation: ₹10,000
- Change in accounts receivable: +₹50,000
- Change in inventory: -₹20,000
- Change in accounts payable: -₹25,000
Solution:
Let’s calculate Radha’s store by using the indirect method
Operating Cash Flow = Net Income +/- Changes in Assets and Liabilities + Non-Cash Expenses
= 1,00,000 – 50,000 + 20,000 – 25,000 – 10,000
Operating Cash Flow = ₹ 55,000
So, we can see that Radha succeeded in generating ₹ 55,000 of cash flows from her operations. This balance reflects that Radha produced enough money from her operations, and ₹55,000 was the balance left (savings) at the end of the year and invest the cash for company growth.
The above mentioned is the concept, that is elucidated in detail about ‘What is Operating Cash Flow’ for the Commerce students. To know more, stay tuned to BYJU’S.
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