Operating cash flow definition
/What is Operating Cash Flow?
Operating cash flow is the net amount of cash that an organization generates from its operating activities. It does not include any investing or financing activities. This information is used to determine the viability of the core operations of a business, since positive cash flow is needed to maintain and grow a firm’s operations over time. Operating cash flow can be a more reliable indicator of financial health than the reported net income of a business, since net income can be altered by non-cash revenue and expense transactions. It is presented within the first section of the statement of cash flows, which is part of the financial statements.
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The Interpretation of Financial Statements
How to Analyze Operating Cash Flow
Operating cash flow is closely watched by analysts, since it can provide insights into the financial condition of a business. In particular, compare the amount of this cash flow to a company's ongoing fixed asset purchasing requirements, to see if it is generating enough cash flow to fund its capital base. If not, it will either be necessary to obtain additional funding to maintain a sufficiently new set of fixed assets, or management can elect to replace assets at longer intervals, which can lead to higher repair costs and more production downtime.
How to Calculate Operating Cash Flow
There are two ways to calculate operating cash flow, which are the indirect and direct methods. The derivation of the two methods is noted below.
Indirect Method
To calculate operating cash flow under the indirect method, subtract all depreciation, amortization, income taxes, and finance-related income and expenses from the reported net income of a business. Conversely, it can also be calculated by subtracting all operating expenses (less depreciation and amortization) from revenues. Depreciation and amortization are subtracted because they are non-cash expenses. The method chosen depends on which information is more readily available.
In addition, the effects of changes in the various working capital line items on the balance sheet must also be taken into account. For example, an increase in accounts receivable represents a cash outflow, while a decrease in accounts receivable represents a cash inflow. Or, to use a liability as an example, an increase in accounts payable is a cash inflow, while a decrease in accounts payable is a cash outflow. This analysis is also conducted for inventory, prepaid expenses, accrued expenses, and accrued revenue.
Direct Method
To calculate operating cash flow under the direct method, a business uses cash-basis accounting to directly track the cash impact of all business transactions. This results in a statement of the cash inflows and outflows associated with a variety of line items, such as the following:
+ Cash collected from customers
+ Interest income and dividends received
- Compensation paid to employees
- Cash paid to suppliers
- Interest paid to lenders
- Income taxes paid
= Operating cash flow
In reality, most businesses use the indirect method to report their operating cash flows, because their accounting systems are already set up to track this information; this is not the case for the direct method, which requires that additional work be completed to report on the required line items.
Example of Operating Cash Flow
As an example of operating cash flow, a business reports cash flow using the indirect method. It reports net income of $100,000, depreciation of $8,000, and income taxes of $30,000. Its accounts receivable increased by $20,000, while its accounts payable increased by $12,000. Its operating cash flow is:
$100,000 Net income + $8,000 Depreciation + $30,000 Income taxes - $20,000 Receivables + $12,000 Payables
= $130,000 Operating cash flow
Operating Cash Flow vs. Net Income
There are significant differences between operating cash flow and net income. While operating cash flow is essentially the cash spun off from operating activities, net income is revenue minus expenses. The net income figure reported by a business can differ substantially from its operating cash flows, because net income includes non-cash revenues and non-cash expenses. For example, revenue might be recorded for which a billing has been issued to the customer, but for which no cash payment has yet been received. Or, a business records depreciation expense or accrues an expense, for which there are no associated cash outflows. These differences can result in operating cash flow being substantially higher or lower than net income. Neither value is more correct than the other; however, when net income persistently exceeds operating cash flows for an extended period of time, this is a possible indicator of financial statement reporting fraud, where the statements are being adjusted to report more income than is really the case.