In modern India, we see new businesses pop up every day. But how many of them are able to survive? Many of them start with a bang but then go out with a whimper before any of us even realize it. If you plan to set up any kind of business, you need to find a way to ensure that your operating costs are sustainable. Keeping track of your operating cash flow will help you do that.
What is the operating cash flow?
The net cash that an organization’s operations generates is the Operating Cash Flow (OCF). It excludes all financial or investment activities. Companies need a positive cash flow to sustain and expand their activities. The OCF helps them with this by offering a way to judge the sustainability of their primary operations.
Both non-cash revenue and cost activities impact the net income. So the OCF activities are a more accurate indicator of financial health. Moreover, for a finance corporation, a cash flow example from an operating activity is the payment of interest.
Analyzing a cash flow statement
Analysts pay particular attention to the OCF statement as it offers insights into the underlying entity’s financial health. To assess whether a firm is in a position to finance its capital base, compare its cash flow to its ongoing need for assets. If the latter exceeds the former, you may need to look for extra financing. Alternatively, the management may decide to replace assets more frequently, which could lead to greater maintenance costs and longer production downtime.
Importance of operating cash flow
By now, you may have a fair idea of why the OCF of a company is important. But in addition to what we have discussed so far, there are a few other things that the cash flow statement can help achieve.
Transparency about and insight into spending habits
The profit or loss statement of a business may not capture many of its payments. Cash flow statements, on the other hand, take a more holistic approach. A profit and loss statement wouldn’t reflect, for instance, payments made to repay a loan. But a cash flow statement would include this data. By doing so, it gives you a better picture of the money spent. That makes your accounts more transparent, which may give you insight into your spending habits.
Better cash planning outcomes
To ensure the success of their initiatives, businesses often develop financial strategies. Despite this, there are still instances where firms cannot implement their strategies or achieve the goals set during the planning stage. By allowing businesses to contrast planned cash flow figures with actual cash flow outcomes, a cash flow statement can help determine if their cash planning was truly effective. Businesses may also use the data to plan for their future better.
Heightened awareness of cash balance
Stakeholders and business owners ought to know the cash flow that’s ideal for their organization. This is one of the most crucial tasks a cash flow statement helps with. It does this by determining whether there is an excess or shortfall of cash. To achieve the ideal cash balance, a deficit-hit business could invest its extra cash, borrow money, or find investors.
Insights into the liquidity position of the firm
A business can learn more about its liquidity status—whether it is improving or deteriorating—using inter-firm and intra-firm cash flow statistics. Additionally, it may assess its liquidity and compare it to other organizations.
Crafting the long-term strategy
The cash flow statement also plays a key role in long-term cash planning. Businesses need long-term financial plans as they play a crucial role in relation to expansion plans. A cash flow statement helps create one and make critical adjustments when needed. It also is useful in assisting the management with priority setting.
How to calculate the operating cash flow
There are typically two ways to calculate the Operating Cash Flow or OCF.
1. The direct approach
You could simply use a straightforward formula. However, as prospective investors won’t learn much from it, businesses use it only to monitor their operational performance internally. The operating cash flow formula is as follows.
Operating cash flow = Total Revenue – Operating Expenses
2. The indirect route
With this approach, you must add the non-cash components to the net income and adjust it for balance sheet changes. However, to account for changes in inventory and accounts receivable, you must also include depreciation in net income.
So the indirect method of determining OCF demands that non-cash items be added to net income. It also involves making adjustments to incorporate changes in net capital.
The operating cash flow formula via the indirect method is:
Operating cash flow = Net income (+/-) Changes in assets and liabilities + non-cash expenditure
Example of operating cash flow calculation
Let’s take an example to understand this OCF formula (indirect formula) better. Suppose the Ram car shop specializes in car tires and accessories. Ram wants to study his financial statement for this year to ensure he has enough money for his future plans. To do it, he lists the following expenses:
- Net income: 1oo,ooo
- Depreciation: 5,000
- Change in accounts receivable: +40,000
- Change in inventory: 10,000
- Change in accounts payable: 15,000
Using the indirect formula, you can calculate the operating cash flow for Ram car shop as follows.
Operating cash flow = Net income (+/-) Changes in assets and liabilities + non-cash expenditure
That is, 1,00,000-40,000+10,000-15,000-5000
That means the operating cash flow is 50,000.
Conclusion
Calculating the OCF helps you gain a better understanding of a company’s operations and expenses. It also helps you create better future plans and guarantee that the company runs sustainably.
FAQs
Can you present an example of an operating cash flow?
Let’s assume there’s a business that reports overall running expenses of $600. If its total revenue of $1,300, by using the direct approach, here’s what its OCF situation looks like.
– Total Revenue = $1,300
– Operating Expense= $600
The operating cash flow is the total revenue minus operating expenses.
So the OCF = $500
How is the OCF ratio calculated?
You will need to derive the cash flow from operations to calculate the operating cash flow ratio. You calculate it by adding the operating income and non-cash costs and subtracting the non-cash revenue.
What do you mean by operating cash flow?
Operating Cash Flow (OCF) is a measure of a company’s ability to generate cash from its core operating activities. It indicates the cash generated or used by day-to-day operations, excluding financing and investing activities, providing insights into a company’s liquidity and financial health.
What is the difference between operating cash flow and cash flow?
Operating cash flow measures cash generated from a company’s core operations, while cash flow encompasses all cash inflows and outflows, including investments and financing activities, providing a broader financial view.
What is profit and operating cash flow?
Profit is the surplus after deducting expenses from revenue, while operating cash flow is the cash generated or used by a company’s core operations, excluding non-operational items like investments.
How do you calculate operating cash flow margin?
The operating cash flow margin is calculated by dividing operating cash flow by total revenue and multiplying the result by 100 to express it as a percentage. It measures a company’s profitability from core operations.
What is another name for operating cash flow?
Operating Cash Flow (OCF) is commonly referred to as “Cash Flow from Operations.” It represents the cash generated from a company’s core operating activities.
