How to Find Operating Cash Flow: Calculation & Formulas
Learn to calculate operating cash flow. Gain essential insights into a company's core financial strength and its ability to generate cash.
Operating cash flow is a financial metric that reveals the cash a company generates from its regular business activities. It indicates how effectively a business generates cash internally to cover expenses and fund operations, without relying on external financing or asset sales. This metric is key for evaluating a business’s financial health.
Understanding Operating Cash Flow
Operating cash flow (OCF) focuses on cash generated or used by a company’s primary business activities, excluding investing and financing. It clarifies a company’s true liquidity and operational efficiency. OCF is a more accurate representation of financial strength than net income alone, as it accounts for actual cash movements.
Net income, on the income statement, uses accrual accounting, recognizing revenues when earned and expenses when incurred, regardless of cash flow. This can lead to a profit with cash shortages, or a loss with cash on hand. OCF adjusts net income for non-cash items and timing differences, offering a clearer picture of cash generated from daily operations.
Gathering Financial Information for Calculation
To calculate operating cash flow, specific financial information is needed from two primary financial statements: the Income Statement and the Balance Sheet. These statements provide the raw data required for both the indirect and direct methods of calculation.
From the Income Statement, Net Income serves as the starting point for the indirect method. Details on non-cash expenses, such as depreciation and amortization, are also extracted, as these reduce net income but do not involve an actual cash outflow.
The Balance Sheet provides information on changes in a company’s current assets and current liabilities between two periods. Relevant current assets include accounts receivable (money owed to the company by customers), inventory, and prepaid expenses. Key current liabilities include accounts payable (money the company owes to suppliers) and accrued expenses. Changes in these working capital accounts reflect how efficiently a company manages its short-term assets and liabilities, impacting its cash position.
Calculating Operating Cash Flow: The Indirect Method
The indirect method of calculating operating cash flow begins with a company’s net income and then adjusts it for items that affected net income but did not involve actual cash movements. This method is widely used due to its simplicity and reliance on readily available financial statement data.
The first adjustment involves adding back non-cash expenses to net income. Depreciation and amortization are common examples, reducing reported profit without a current cash outflow. Other non-cash items added back include stock-based compensation, deferred taxes, and impairment charges, as these also do not involve cash payments.
Next, adjustments are made for changes in working capital accounts. An increase in a current asset, such as accounts receivable or inventory, means cash was used or tied up, so it is subtracted from net income. For example, if accounts receivable increases, it indicates that sales were made on credit, and the cash has not yet been collected. Conversely, a decrease in a current asset means cash was collected or freed up, so it is added back.
For current liabilities, the opposite adjustments apply. An increase in a current liability, like accounts payable or accrued expenses, indicates the company conserved cash by delaying payments, so this increase is added to net income. This is because the expense is recognized in net income, but the cash payment has not yet occurred. A decrease in a current liability, however, means cash was used to pay off obligations, and this decrease is subtracted. These adjustments convert the accrual-based net income into a cash-based operating cash flow figure.
Calculating Operating Cash Flow: The Direct Method
The direct method calculates operating cash flow by presenting major classes of gross cash receipts and gross cash payments related to operating activities. Unlike the indirect method, which starts with net income, the direct method directly lists cash inflows and outflows from operations. This approach provides a clear, itemized view of where cash came from and where it was spent in the company’s daily operations.
To prepare a direct method cash flow statement, key categories of cash flows are identified. Cash inflows include cash collected from customers, derived by adjusting sales revenue for changes in accounts receivable. For example, if sales revenue is $100,000 and accounts receivable increased by $5,000, then cash collected from customers would be $95,000.
Cash outflows from operations include cash paid to suppliers, cash paid to employees, cash paid for operating expenses, interest paid, and income taxes paid. Cash paid to suppliers is determined by adjusting the cost of goods sold for changes in inventory and accounts payable. Similarly, cash paid to employees is derived from salary expense adjusted for changes in salaries payable. While the direct method offers a more transparent view of cash transactions, it is less commonly used by public companies in the United States because the information required can be more difficult and time-consuming to compile.