Operating Cash Flow (OCF)

Operating cash flow (OCF), often called cash flow from operations, is an efficiency calculation that measures the cash that a business produces from its principal operations and business activities by subtracting operating expenses from total revenues. Basically, it shows how much cash flow is generated from the business operations without regard to secondary sources of revenue like interest or investments. For example, a company that manufactures widgets must make more money selling them than it cost to produce them. In other words, cash inflows must always be greater than cash outflows in order for the business to be profitable and able to successfully pay its bills.

What is Operating Cash Flow?

This is an important measurement because it allows investors and creditors to see how successful a companyís operations are and if the company is making enough money from its primary activities to maintain and grow the company. This concept is particularly important for financial forecasting because it can help show the health of a company. Take Circuit City for example. For the last few years of their operations, they were losing money on all of their retail activities, but they were making money on maintenance contracts and customer financing. What does that tell us about the core business? Itís unhealthy and can survive very long.

This is why all public companies must report this number in their quarterly financial reports and annual cash flow statement. GAAP also requires companies to use the indirect method to compute this figure.

Now that you understand its importance, letís answer the question what are operating cash flows?

Formula

The operating cash flow formula can be calculated two different ways. The first way, or the direct method, simply subtracts operating expenses from total revenues.

Operating Cash Flow

This calculation is simple and accurate, but does not give investors much information about the company, its operations, or the sources of cash. Thatís why GAAP requires companies to use the indirect method of calculating the cash flows from operations. This method is exactly what it sounds like. Itís an indirect, round about way to calculate it.

The operating cash flow equation for the indirect method adjusts net income for changes in all non-cash accounts on the balance sheet. Depreciation and amortization is added back to net income while it is adjusted for changes in accounts receivable and inventory.

Operating Cash Flow Formula

As you can see, this OCF formula much more complicated, but it gives much more information about the companyís operations. Itís essentially converting the operating section of the accrual income statement to a cash basis statement.

Now that we know how to calculate operating cash flows, letís look at an example.

Example

Billís Guitar Shop is a music retail store that specializes in guitars and other instruments. Billís main competition is Guitar Center and he wants to analyze ways he can improve his business. Billís year-end financial statements show the following numbers.

  • Net income: $100,000
  • Depreciation: $10,000
  • Change in accounts receivable: +$50,000
  • Change in inventory: -$20,000
  • Change in accounts payable: -$25,000

Using the indirect method can be confusing because you are converting the accrual net income to a cash basis net income. Thus, any increase in assets must be subtracted out, while a decrease in assets must be added back in. The opposite is true for liabilities. Increases are added back while decreases are subtracted out. I know this sounds confusing, but you have to think about it in terms of cash. If inventory went down during the year, it means that inventory was sold and cash was received. Therefore, a decrease in inventory must be added back to net income.

Here how to calculate OCF for Billís store using the indirect method:

Operating Cash Flow Example

As you can see, Bill was able to generate $55,000 of cash flows from his operations. This means that Billís operations generated enough money to pay its bills and have $55,000 left over at the end of the year. This money could be reinvested back into the business by purchasing more inventory, a bigger storefront, or Bill could pay himself a dividend for a successful year. Either way, it shows that the retail operations are successful enough to pay the associated expenses and fund some level of expansion and company growth.

Analysis

Many investors prefer analyzing cash flow number compared with other ratios because they are largely immune from management altering them. For instance, many performance ratios can easily be manipulated by managementís choice of accounting principle or practice. Cash flows arenít so easily manipulated. The company earns cash and spends cash. Investors also like analyzing cash flows because it presents a stripped down version of the company where itís much easier to see problem areas in the operations.

For instance, a company may have high net income, but low OCF. Why is this? Maybe itís because they are having a difficult time collecting receivables from customers. Conversely, a company might have a low net profit and a high cash flow from operations. This might happen because the company is generating huge revenues but reducing them with accelerated depreciation on the income statement. Since the depreciation is added back into net income in the operating cash flow calculator, the accelerated depreciation doesnít affect OCF.

Just remember that the cash flow trail isnít as easily manipulated. Thus, it tends to be a better indicator of a companyís health and future success.





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