A company’s cash flow generated through core operations is known as Operating Cash Flow (OCF). This is an important metric for gauging the financial health of a company and its standing among competitors. Information on the cash flow from operating activities of a firm is also a key part of fundamental analysis and helps investors make sound decisions on their investments.
In this article, we will discuss the meaning of OCF, understand the various methods for its calculation, and delve into the importance of measuring the cash flow from operations for businesses and investors.
Cash flow from operating activities (OCF)
OCF, or the cash flow from operating activities, is a measure of the cash generated by a company through core business activities. It is a real measure of the volume of cash generated, which helps evaluate business targets. Most importantly, OCF is crucial for determining the success of a business strategy and planning operational upscaling.
Under the ambit of OCF, cash flow from operating activities like the following is accounted for:
- Cumulative revenue from the sale of services and goods in a set period
- Expenses of suppliers for goods and services
- Production expenses
OCF is a crucial part of a company’s cash flow statement, along with other metrics like cash flows from investments and free cash flow.
Calculation of cash flow from operations
There are two main methods to calculate cash flow from operating activities. These are the direct method and indirect method. Let us look at these in detail:
Direct method
The direct method is a simple and accurate way to calculate the OCF of a company. An important facet here is that because of its simplicity, it often ends up providing less insights regarding a company’s performance. Thus, it is majorly used by companies to track their progress rather than being relied on by investors.
The formula to calculate OCF through the direct method is:
OCF = Cumulative Revenue - Operational Expenses
Some of the elements included in the calculation of OCF through the direct method are:
- Employee salaries
- Expenses incurred on suppliers and vendors
- Revenue from clients and customers
- Income tax and interest
- Income from interests and dividends
Indirect method
The indirect method is more complex than the direct method. In this method, non-cash accounts are also included while calculating OCF. Non-cash expenses include depreciation and amortisation, deferred tax, and unrealised losses or gains.
The formula to calculate cash flow from operating activities through the indirect method is:
OCF = Net income +Non–cash expenses - (Increased) Working capital
Also read: Cash Flow vs Fund Flow
Example for calculating cash flow from operating activities
Let us understand the OCF calculation through an example. Consider the following data regarding the performance of the company ‘XYZ’ for the financial year 2024:
- Net income: Rs. 10 lakh
- Non-cash expense: Rs. 1 lakh
- Increased working capital: Rs. 2 lakh
In this case, with the above-mentioned figures, the OCF can be calculated through the indirect method as follows:
OCF = Rs. 10 lakh + Rs. 1 lakh - Rs. 2 lakh = Rs. Rs. 9 lakh
In this example, the net income of a business is the starting point in calculating the cash flow from operating activities. With the net income, we then figure out the net non-cash expenses, taking into account depreciation and amortisation, and then plug in the change in working capital to calculate the OCF.
Importance of operating cash flow
Now that we know the meaning—and how to calculate OCF, let us look at its significance in understanding a company’s functioning and cash flows. Consider the following:
- Cash flow from operating activities is a direct indicator of a company’s financial health when studied in conjunction with other metrics like net income and profits. It is useful to businesses and investors.
- Businesses can track OCF changes to gain insights into their performance according to their financial goals.
- Investors can study OCF to make informed investment choices.
- A negative OCF indicates a business’s insufficiency in financing its operations through its core business activities. This further denotes that the business needs to borrow cash to continue its operations.
- OCF is a simple and pure method of accounting for cash flows, as it is transparent in calculation and inclusions.
- Measuring cash flow from operating activities enables overcoming some accounting limitations, like a mismatch between revenue accounts and actual cash flows.
Also read: Discounted Cash Flow
Conclusion
Operating cash flow (OCF) is a crucial metric for evaluating a company's financial robustness, derived directly from its core business activities. Calculated through either the direct or indirect method, cash flow from operating activities provides valuable insights into operational efficiency and financial sustainability. Businesses leverage it for internal performance monitoring, while investors rely on it for comprehensive financial analysis.
A negative OCF serves as a warning sign of potential financial hurdles, necessitating proactive measures. OCF's transparency and simplicity as a measure of a company’s financial health enhance the accuracy of financial reporting and help overcome some accounting limitations. A robust understanding of OCF can empower you to make well-informed investment decisions, foster sustained growth for companies, and promote stability within the dynamic and competitive business landscape.
