If you’re a beginner when it comes to finances, you would probably want to know what the operating cash flow means. Basically, it’s an efficiency calculation that shows the amount of cash generated by a company’s regular operating activities during a certain time. Therefore, it shows the cash flow generated from the business operations without concern to any secondary source of revenue such as investments or interest.
Do you want to know more about this calculation? Then, you’ve come to the right place.
Operating Cash Flow – How important is it?
Operating cash flow is important because it lets creditors and investors see the success of a firm’s operations and if it’s making enough cash to maintain itself and grow. When it comes to financial forecasting, this calculation is relevant, as it can show the company’s health.
As an example, there were situations in which companies were losing income on all the retail activities. However, it was maintenance contracts and customer financing that was generating income. Therefore, this shows that the companies were unhealthy.
For this reason, every public company must report this number in their annual cash flow statement and quarterly financial reports.
Analyzing OCF
Many times, investors would rather analyze the cash flow number than other ratios, because they are immune to management altering them. There are many ratios that can be exploited by management’s choice of accounting principle or practice.
Meanwhile, a cash flow is not so easy to exploit. A firm earns money and spends it. Moreover, investors prefer analyzing a cash flow because it shows the problem areas in the operations in an easier way.
Take this as an example: you have a company with a high net income, but the operating cash flow is low. Do you know what the reason may be? It could be because they can hardly collect receivables from customers.
In another situation, your firm may have a low net income and a high operating cash flow. The reason may be the fact that the company generates huge revenues while reducing them with accelerated depreciation on the income statement. Considering the depreciation is added back to the net income in the OFC calculator, the sped up depreciation has no effect on the OFC.
What is the formula?
In order to calculate it, you need to know that OFC has a direct formula and indirect formula. The direct one is like this:
Although this calculation is easy, investors can’t access so much information about the company through it.
Therefore, they are required to use the indirect method.
The indirect one adjusts net income for modifications in all non-cash accounts on the balance sheet. Also, amortization and depreciation are added back to the net income, and it’s adjusted for modifications in inventory and accounts receivable. It’s calculated like this:
Hopefully, you are now aware of the operating cash flow and know what it brings to the table. It indicates a company’s health and potential success, so it’s important for companies to know about it.