Understanding Operating Cash Flow Calculation

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Operating Cash Flow Calculation

Monitoring the financial situation of a company with transparent accounting is essential. The annual financial statement provides significant information for decision-making and strategic planning.

Key financial indicators make it easier to compare different timeframes or companies. One of these parameters is cash flow. It is made up of several categories, each shining a light on company performance from a different angle.

In this article, we introduce you to Operating Cash Flow (OCF) in more detail.

Two main features of OCF are:

  • It is an indicator of the internal financing power of a business.
  • It provides information about the competitiveness of the company.

 

What exactly is Operating Cash Flow?

First, let us define what cash flow is. Quite simply, cash flow is the balance of incoming and outgoing payments in a specified accounting period.

So, obviously, the goal of any entrepreneurial activity is to achieve a positive cash flow.

When calculating a company’s cash flow, income and expenses that do not affect payments in the period considered – such as depreciation or provisions – are not considered.

Overall cash flow, as shown in a company’s cash flow statement, is composed of three parts:

  1. Operating Cash Flow
  2. Investment Cash Flow, and
  3. Financing Cash Flow.

OCF exclusively takes into account cash flows from operating activities. Consequently, it reflects only a portion of all cash inflows and outflows. Operating Cash Flow, for example, includes:

  • Incoming customer payments
  • Reimbursements from suppliers
  • Interest
  • Taxes
  • Wages and salaries

In contrast to other performance indicators, such as net profit, cash flow is more meaningful. One reason is that there is less room for maneuver to interpret it, unlike some other measures found on balance sheets.

Operating Cash Flow derives its strength from focusing on the results of the regular operations of a company. That can help uncover the true viability of a business.

Take the example of a car manufacturer that also offers financing to buyers. It is theoretically possible that the financing business’s contribution puts net income into positive territory while the core activity of building cars is, in fact, in the red. Operating Cash Flow would detect that problem.

Cash flow should by no means be confused with a company’s profit. Due to factors like depreciation, a negative cash flow may coincide with a positive profit and vice versa.

In summary, Operating Cash Flow shows which liquid funds (“cash”) regular business activities generated in a given period. A positive cash flow means an inflow of cash, and a negative cash flow represents an outflow.

Basically, to calculate a value for OCF, all expenses related to the actual creation of a product or provision of a service, in other words, all operating costs, are deducted from the revenue of that period.

International accounting standards like the

  • International Finance and Reporting Standards (IFRS)
  • United States Generally Accepted Accounting Principles (US GAAP)

allow for two methods to calculate Operating Cash Flow: direct and indirect. The following sections describe how this works.

 

How to calculate OCF

The ways to calculate Operating Cash Flow are best understood when keeping in mind what role the indicator has in accounting: to provide a transparent image of how much cash is left from regular business activities after deducing the cost of doing business.

Although IFRS and GAAP both allow for the direct and indirect method, the former is often carried out for internal purposes only. That is because all business transactions are known inside the company.

On the other hand, external stakeholders usually only have access to the indirect calculation because not all necessary payment flows have to be published on the corresponding level of detail.

To make the calculation easier, you may want to use an online Operating Cash Flow Calculator.

Let us look at the two calculation methods in detail.

 

Direct Method

The direct method to calculate Operating Cash Flow balances all cash-effective transactions of a fiscal period. It can be described in the following formula:

The formula means that all inflows and outflows of cash during a period are recorded and balanced out. Which concrete payments have to be included in the calculation depends on the situation of a given company.

An example of direct Operating Cash Flow calculation may look like this:

Revenue

  • tax credits
  • other cash received from customers
  • Salaries
  • Taxes paid
  • Other expenses

==============================

= Operating Cash Flow

 

Indirect method

The indirect method of determining cash flow, on the other hand, is based on the operating result from the income statement. To calculate Operating Cash Flow, net income is adjusted as described in the following formula:

Put differently, this method starts with net income and arrives at a cash basis by excluding all elements that are not cash-effective, such as depreciation or accruals.

Example:

Net income

  • accruals
  • depreciation expense
  • Increase in accounts receivable

==============================

= Operating Cash Flow

This method’s logic is that the depreciation of buildings, for example, reduces profit because it is considered an expense. However, that expense is not offset by a cash payment in the period under review. The payment was already made when the building was acquired or built.

Thus, depreciation is non-cash and must be adjusted. The corresponding values are added back to arrive at the cash flow because all depreciation in the accounting system has “incorrectly” reduced earnings.

The same principle holds for the positions subtracted.

 

The Bottom Line

Operating Cash Flow is a key financial indicator that is indispensable for any serious investor. It is a measure that is hard to manipulate and provides – together with investing and financing cash flow – one of the most comprehensive and truthful representations of a company’s operative performance.

It is important to understand that there is no universally valid formula for calculating Operating Cash Flow that includes every cash position necessary. The reason is that what is to be included in the calculation depends on the specific situation of each company.

On Accounting Portal – Tax Resources for Accountants and Small Businesses (U.S.), an online OCF calculator is available to assist you with your calculation.