What does operating cash flow mean?

Revolut Contributor

 · 07/29/2020  · 07/29/2020

The operating cash flow of a business is one of three main sections in its cash flow statements. The other two parts are its investing activities and financing activities. As the name implies, this type of cash flow represents the cash position of the business due to everyday trading activities, as opposed to, say, its investments in new machinery or the repayment of long-term loans.

Cash flow is one of the ‘big three’ financial statements, alongside the income statement and balance sheet even though small companies are not obliged to produce them. The cash flow statement will reveal the amount of cash available to a business in a given period – for instance, a quarter or year.

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What is included in operating cash flow?

Operating cash flow (OCF) shows cash flows relating to operating activities. Here are a few examples:

  • Cash received from customers
  • Cash paid to suppliers and for staff salaries
  • Cash movements related to the interest owed on finance
  • Cash movements related to tax (e.g. VAT payments or refunds)

The business can choose whether to include its dividend payments to shareholders in this section or to pop these into financing activities. The Association of Accounting Technicians (AAT) advises that operating activities is the ‘default’ classification for a cash flow statement and that cash flows which are not investing nor financing may get dumped into this catch-all category.

How do you calculate operating cash flow

There are two ways to work-out the OCF meaning that business owners have a choice of method. The operating cash flow formula will then obviously depend on which method you opt to adopt.

The direct method takes the opening cash balance at the beginning of the period and records each movement of cash flow from operations to be either a positive or negative effect on the net balance. This method is more accurate but time-consuming and requires detailed information on transactions.

A more popular choice is the indirect method. This approach takes the net profit {RB26} for the period and adds-back the value of non-cash transactions such as depreciation or payments made in shares. The final step is to adjust the operating cash balance to show changes in working capital. While this sounds fiddly, it’s easier to calculate. We cover the indirect method here {RB38} and formula is below:

Operating cash flow (OCF) = Net Profit + Non-cash expenses +/– Changes in working capital

Is operating income a cash flow

In a word, no. Operating income is another term for operating profit {RB22}, and this is not the same as cash flow. Profit is the amount by which revenue exceeds costs over a given period {RB27}, whereas the cash flow merely records the actual movements of cash during that time frame.

The business is typically obliged to record revenue when the goods that it sells in a transaction change hands, whereas the cash might get paid later. We describe revenue recognition here. {RB31}

Let’s take an example. The fictional Lemon Jelly scooter retailer sells ten of its Super Citrus models in January. The client pays a 50% deposit, and Lemon Jelly ships the goods on the same date. The balance gets settled in April. Operating income (i.e. profit) for Q1 shows the full value of the scooters as revenue, but operating cash flow for the period only records the deposit.

Why is operating cash flow important?

If a business does not have a positive cash flow from operating activities, it will probably have to source short-term finance to cover the shortfall to stay afloat. If the cash flow from operations is consistently negative (i.e. cash inflows are lower than cash outflows), the business might need to raise capital or take on long-term debt.

The smart way to assess this is with the operating cash flow ratio. This liquidity metric reveals the extent to which a business can pay its current debts based on its operating cash flow. The formula is below, and if the ratio is lower than one for any given period, it shows that the business is unable to cover its liabilities with the cash that it generates from its core operation in this timeframe. Bad news.

Operating cash flow ratio = Cash flow from operating activities / Current liabilities

While operating cash flow is a crucial metric, it’s not life-or-death for a business, as there might be sound reasons for a shortfall, such as snapping-up stock that’s eventually profitable. Here’s hoping.

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