What is Operating Cash Flow?
Operating Cash Flow represents the amount of cash a company or business generates from its business operations. Operating cash flows directly relate to a company’s cash flows. Therefore, it shows whether the company can generate sufficient cash inflows from its operations to invest in its operations. In the case of net cash outflows from operations, companies need to utilize other sources of finance.
A company’s Cash Flow Statement consists of its operating cash flows, also known as cash flow from operations. For stakeholders, operating cash flows can indicate how much cash flows a company makes from its operations. While the other sources of finance are also crucial, operating cash flows relate to a company’s performance directly.
What is the Operating Cash Flow formula?
The operating cash flow formula is straightforward. With the direct method, the formula is the difference between the cash inflows and outflows from operations. However, separating the cash flows may not always be possible. Therefore, companies may also calculate their operating cash flows from their net income.
The net income approach is applicable in the indirect method to the Cash Flow Statement. This formula takes a company’s net income and adds back any non-cash items to it. After that, it adjusts any fluctuations in the company’s working capital to the amount to calculate its operating cash flows. Therefore, the formula will be as follows.
Operating Cash Flows = Net Income + Non-Cash Items + Changes in Working Capital
The changes in working capital represent any fluctuations in a company’s inventory, accounts payable, and accounts receivable balances. An increase in inventory and accounts receivable balances represent a negative adjustment. In contrast, an increase in accounts payable balances is a positive adjustment.
Example
A company, Blue Co., had a net income of $100,000 during the financial year. The company also charged depreciation of $20,000 and amortization of $10,000 to its Income Statement. Given below is an excerpt of Blue Co.’s working capital.
|
Item |
Last Year ($) |
Current Year ($) |
|
Inventory |
35,000 |
30,000 |
|
Accounts Receivable |
40,000 |
55,000 |
|
Accounts Payable |
50,000 |
40,000 |
There is a reduction in Blue Co.’s inventory balance. Therefore, it represents a positive adjustment to the operating cash flows. The increase in accounts receivable and the decrease in accounts payable balance both represent negative adjustments. Therefore, Blue Co.’s operating cash flows will be as follows.
|
Item |
Amount ($) |
|
Net Income |
100,000 |
|
Add: Depreciation |
20,000 |
|
Add: Amortization |
10,000 |
|
Add: Decrease in Inventory Balance |
5,000 |
|
Less: Increase in Accounts Receivable Balance |
(15,000) |
|
Less: Decrease in Accounts Payable Balance |
(10,000) |
|
Operating Cash Flows |
110,000 |
What is the importance of Operating Cash Flow?
Operating cash flows are of significant importance for all stakeholders. Most stakeholders prefer it because it does not consider any one-off transactions. These cash flows specifically relate to a company’s business operations. Therefore, they can show a company’s efficiency in generating cash flows from its operations.
For some stakeholders, a company’s operating cash flows are significantly more critical compared to net income. It is because net income consists of several non-cash items, which operating cash flows neglect. Similarly, operating cash flows are also not easily manipulatable, which adds to their importance.
Conclusion
Operating cash flows represent cash flows that companies or businesses generate from their business activities. There are two methods that companies may use to report their operating cash flows. However, the indirect method is the most common.
