Operating Cash Flow (OCF)
Operating Cash Flow is called cash flow from operation. It is the efficiency calculation which is used to measure the cash which a company produce from its operation and measure the business activity by subtracting the operating expenses from total revenue.
OCF shows that the operation of the company produces how much cash without regard to interest or investment.
For example, a manufacturing company sells product and make more money as compared to the expenses of the product.
In other words, cash outflows must be less than cash inflows so that the company is profitable and easily pay its bills.
What is Operating Cash Flow?
Investors and creditors use OCF to find the status of the company whether the company is successful or not. Investors find that the company can make enough money from the operations of the company to maintain and grow the company or operation of the company can’t make enough money. This is an important concept because it shows the health of the company.
Public companies report this number on a quarterly financial statement or annual financial statement to find the health of the company.
Operating cash flow (OCF) formula can be calculated by subtracting the operating expenses from total revenue.
Operating Cash Flow
Operating Cash Flow = Total revenue – Operating Expenses
The above equation of operating cash flow is so simple to calculate but it does not give the information of cash, cash source, and operation of the company. That’s why GAAP requires the companies to use the indirect method of calculating cash flow from operations.
For the indirect method OCF equation adjust the net income for changing in the noncash account on the balance sheet. After the adjustment of it in the account receivable and inventory, depreciation and amortization added back in the net income.
Operating Cash Flow
Operating cash flow = Net Income +/- Changes in Assets and Liabilities + Noncash Expenses
As compared to direct method OCF formula this is a complicated formula but it gives more information about the operation of the company.
Now we take the operating cash flow (OCF) example to understand this in a better way.
Now we take the example of Maria’s guitar shop. Her main competition is guitar center and she want to analyze the way through which she can improve her business. At the end of the year her financial statement shows the following numbers.
- Net income = 100,000 dollars
- Depreciation = 10,000 dollars
- Change in account receivable = 50,000 dollars
- Change in account payable = -25,000 dollars
- Change in inventory = – 20,000 dollars
Due to the conversion of the accrual net income into the cash basis net income indirect method confusing. So increasing in the assets must be subtracted and decreasing in the assets must be added back in. It is so confusing in the term os assets so we take this in cash form for better understanding. If the inventory goes down it means that it converts into the cash So decreasing in the inventory must be added back in the form of cash to net income.
Here we calculate the operating cash flow of Maria’s shop
Operating Cash Flow
$55,000 =$100,000 – $50,000 + $20,000 -$25,000 +$10,000
From the above result, it is clear that Maria generates 55,000 dollars from her operations. So left amount after the paying of bills at the end of year Maria has 55,000 dollars. She can invest this amount for new business or reinvest in the current business.
Mostly analysts compare the cash flow number with other ratios. Many ratios can easily be manipulated by the management but cash flow ratio cannot be easily manipulated by the management. The company earned cash and spend cash. Analyst like to analyze the cash flow of the company because through this, analysts easily see the area of the operation which has the problem.
If the net income of the company is high but OCF is low it may be due to the bad receivable performance from the customer. It may be because of the high revenue gain by the company but reduce it with accelerated depreciation on the income statement. Since depreciation added back in the net income in operating cash flow calculator, accelerated depreciation does not affect the operating cash flow.
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