How To Calculate Operating Cash Flow (OCF)

There are several calculations and projections you need to complete as a business owner (or accountant). But, none of them matter if your company is not profitable.

So how do you know if your company is profitable? Your net income, EBIT, and overall cash flow can give you an idea, but they won’t give you the full truth, the whole picture.

If you’re trying to determine your company’s true profits, calculate your financial projections, or secure outside funding, there is one number you need to know: your operating cash flow (or OCF).

What Is Operating Cash Flow (OCF)?

Found in the first section of your company’s cash flow statement, operating cash flow is a financial measurement that shows how much cash is generated from your business’s core operations. This is sometimes referred to as cash flow from operating activities, cash flow provided by operations, or free cash flow from operations.

Your operating cash flow excludes other income sources of revenue, like investments or financing. It solely focuses on core operating activities involved in the day-to-day of your business.

Understanding the Cash Flow Statement

If you are running a business or working in accounting, you should be intimately familiar with the cash flow statement (CFS). This is a financial statement that summarizes the cash and cash equivalents coming and going from your company.

Cash flow statements are a mandatory part of your financial reporting and have been since 1987. Alongside your cash flow statement, you will find that the balance sheet and income statement complement well.

There are three types of cash flow represented on the cash flow statement:

1. Operating cash flow. AKA cash flow from operating activities. Focuses on activities businesses use to produce net income.

2. Investing cash flow. AKA cash flow from investing activities. Focuses on transactions related to long-term investments.

3. Financing cash flow. AKA cash flow from financing activities. Focuses on changes in long-term liabilities and equity.

Investors and creditors pay attention to your CSF. It can tell them about your company’s financial health and if you have the liquidity to cover your expenses and pay your debts on time.

It should be noted that the cash represented on this statement is not equivalent to the net income of your company. Your cash flow statement only notes actual cash-on-hand, not any revenue accrued from sales made on-credit or unpaid invoices.

Your company may appear profitable in terms of overall cash flow, but when you dig deeper, that profit is fueled by investments and other outside forms of income. The core business isn’t profitable or sustainable.

Cash flow as a whole does not give you a clear picture of your profits, but the operating cash flow does.

Calculating Operating Cash Flow (OCF)

There are two methods of calculating and presenting the operating cash flow on your cash flow statement under the generally accepted accounting principles (GAAP)—the direct method or the indirect method.

Though the direct method is acceptable, other reconciliations will need to be presented if this method is chosen. You would also need to disclose the reconciliation of net income to the operating cash flow that would have been reported with the indirect method.

The indirect method may be a more complicated process, but it is the more acceptable method under the GAAP.

There are several calculations and pieces of information required for either method. To calculate your operating cash flow, you will need a working understanding of the following:

• Operating expenses. Operating expenses (OPEX) are expenses that normal business operations generate. These include things like rent, inventory costs, payroll, insurance, marketing, etc.

• Net income. A company’s net income, sometimes referred to as net earnings or net profit, is the gross income minus taxes and other allowable deductions (cost of goods sold, for example).

• Non-cash expenses. Non-cash expenses are expenses that do not involve an actual cash payment. Depreciation, amortization, and stock-based compensation are all considered non-cash expenses.

• Assets and liabilities. Your assets are what your company owns, and your liabilities are the debts your company owes. You will find both on your balance sheet—assets on the left and liabilities on the right. These can include increases in accounts receivable, inventory, accounts payable, etc.

1. Indirect method. The indirect method relies on accrual accounting, an accounting method where revenue or expenses are recorded when the transaction occurs versus when the payment is made or received.

   With this method, you begin with net income. You will then work backward to determine the cash basis figure for the accrual period.

   If the payment noted in net income has not been received, then the net income is overstated. The cash flow statement would need to show the reduction to reconcile the numbers.

   The formula used in the indirect method is:

   Operating Cash Flow = Net Income +/- Changes in Assets Liabilities + Non-Cash Expenses

   Due to the formula elements, the balance sheet and income statement will be needed to calculate your operating cash flow properly.

2. Direct method. The direct method can be used if a company records all transactions on a cash basis. By doing so, they use actual cash inflows and outflows and do not need to make all of the necessary adjustments present in the indirect method.

   While this may seem like a less complicated process, it is more time-consuming in the long term. There is a significant amount of time and effort that goes into recording transactions on a cash basis.

   With the extra effort of accounting for the direct method paired with the additional reconciliations that need to be made under GAAP, the indirect method is the more commonly used practice.

   The formula used in the direct method is:

   Operating Cash Flow = Net Income – Operating Expenses

Indirect Method vs. Direct Method

The indirect method is the more popular choice among companies. Since the accrual method is a common accounting method used, the indirect method makes the most sense. Though the formula makes this method seem more complicated, it is simpler in the long term.

Surprisingly, the Financial Accounting Standards Board (FASB) recommends that companies use the direct method when calculating operating cash flow. This method provides a clearer picture of cash flow throughout the accounting period than at the end when all calculations are made.

However, the FASB requires companies who use the direct method to submit a reconciliation report. The reconciliation report is the report disclosing the reconciliation of net income to the operating cash flow.

This reconciliation is not required in the indirect method because that method already includes this in the formula calculations.

Operating Cash Flow (OCF) vs. Net Income and Earnings Before Interest and Taxes (EBIT)

To find the differences between these three terms, it is best to define each in succession properly.

We know that operating cash flow is the actual cash moving in and out of your company due to its day-to-day operations. It accounts for the cash when it is received and when it is removed.

Operating Cash Flow = Net Income – Operating Expenses

As you can see from the formula above, we must first know our net income to determine our operating cash flow.

On the other hand, net income is the profit your company has earned during the accounting period. To calculate net income, you begin with gross income and subtract taxes and expenses.

Earnings before interest and taxes, or EBIT, is another indicator of a company’s profitability. It is sometimes referred to as operating earnings or operating profit. To calculate EBIT, you begin with gross income and subtract expenses, excluding taxes and interest. It is essentially your net income before you remove the tax and interest expenses.

While all three are indicators of profitability and numbers that investors and creditors pay attention to, they are not quite the same. All three are used for different purposes and are found on different accounting forms.

The Importance of Calculating Operating Cash Flow (OCF)

Aside from it being a required accounting report, this is an extremely useful calculation for your business. It can help you determine your company’s financial success and whether or not your core business is sustainable.

In addition to these being important numbers for the company itself, it is an important number for those who work with your business.

Financial analysts will often prefer to focus on operating cash flow. It provides them with a clearer picture of the business’ profitability and sustainability.

Investors will also be more interested in the operating cash flow versus net income or other numbers. This is for many of the same reasons that financial analysts prefer this calculation.

If your company requires outside funds, whether through investors or a loan, you will again need the operating cash flow as well. Net income can be deceiving. With the operating cash flow, you get a clearer, more accurate picture of your company’s income.

Author

Samantha Goddiess

Samantha is a lifelong writer who has been writing professionally for the last six years. After graduating with honors from Greensboro College with a degree in English & Communications, she went on to find work as an in-house copywriter for several companies including Costume Supercenter, and Blueprint Education.