Why is operating cash flow important?
Operating cash flow is a tool used by financial analysts to assess a company’s true financial health. Its strength comes from the fact that it is typically unaffected by isolated anomalies. It is useful for providing a clear picture of financial standing because of this.
For instance, a significant increase in revenue from a large booking may temporarily inflate some figures and give the impression that the business is more successful. A surplus in operating cash flow without a high net revenue could also point to other problems, such as a balance sheet with multiple fixed assets and accelerated depreciation calculations. The company can use this financial information to inform business decisions that alter their competitive position.
Using this data can also help business leaders understand what innovations, infrastructure, and new resources they can invest in without having to borrow money. Operating cash flow enables companies to make improvements that advance them in the market, improving their ability to compete.
What is operating cash flow?
Operating cash flow is the measurement of a company’s ability to spend money from normal business operations. When it’s positive, it means that the company has enough money to finance its operations. Without operating cash flow, businesses are forced to look for capital from lenders and investors to invest in their own success.
The value at the top of a balance sheet, sometimes called “cash flow from operating expenses,” represents the revenue generated by routine business operations like producing and selling goods or rendering customer services. This information acts as a fundamental metric that depicts the stability and success of a company’s finances.
A cash flow statement, which shows the inflow and outflow of all cash in a business, includes information on operating cash flow (OCF). The cash flow statement typically combines data from the income and balance sheets and can be presented directly or indirectly, as will be covered in more detail below. Based on the amount of cash and cash equivalents coming in and going out of the business, a cash flow statement shows how effectively a company manages its cash.
How to present operating cash flow
On a cash flow statement, operating cash flow can be displayed using one of two main methods. They are both direct and indirect, and the following details will be provided:
1. Direct presentation
Revenue is recorded when cash is received in a direct presentation cash flow from operating expenses. As a result, the cash flow presentation shows the actual amounts received and the expenditures made during an accounting reporting period. This method of reporting reflects actual cash in-flows and out-flows. Examples of operating cash flow in this context include:
2. Indirect presentation
Its more common for businesses to use indirect presentation. Using this method, accountants assess operating cash flow in relation to revenue vs. actual money received. This approach starts with net revenue and subtracts cash flow from that amount.
The top row of a statement of cash flow with an indirect presentation would have one column for net income. Below that, additional rows display gains and losses related to items that make up operating income, such as depreciation expense, amortization, cost of doing business expenses, investment interest earned or spent, sale of equipment and property, and more.
The total cash from operating activities is shown at the bottom of the report after net income has been adjusted to reflect all inflows and outflows.
Indirect vs. direct presentation: Which to choose?
It’s crucial to choose the approach that is best for your company.
For many businesses, the indirect method of reporting cash flow is practical. One is that a lot of businesses account for revenue using the accrual method, which records income as it is earned rather than when it is deposited into the business’s account. This widespread accounting practice is consistent with the indirect method.
Its also a useful resource because its easier to handle. Since it is a straightforward deduction of net income and the line items can all be found on an accurately prepared income statement and balance sheet, creating a cash flow statement only requires entering the necessary information and computing the result.
Although it is simpler and more common to prepare your next cash flow statement using the indirect method, regulatory bodies occasionally demand greater accuracy from the companies they enforce compliance with.
The Financial Accounting Standards Board (FASB) advises businesses to create a cash flow statement using the direct method. However, in addition to the already complex method of accounting for cash flow, FASB also mandates that accountants who use the direct method adhere to similar reporting requirements that would have been present in the indirect method.
All accountants who employ the direct method are required by FASB to produce a reconciliation report to guarantee the accuracy of cash reporting. If you work in a highly regulated sector, you might find that reporting cash flow using the direct method and a reconciliation statement is more compliant than using the more widely used indirect method.
Operating Cash Flow Explained
FAQ
What do you mean by operating cash flow?
Operating cash flow (OCF) is a metric used to determine how much money a company generates through regular business operations. Operating cash flow shows whether a business can produce enough positive cash flow to support and expand its operations; if not, it may need outside financing for capital expansion.
How do you calculate operating cash flow?
- OCF is calculated as (revenue minus operating expenses) plus depreciation, income taxes, and any changes to working capital.
- OCF is the sum of net income, depreciation, and working capital changes.
- Net income less changes to working capital plus non-cash expenses equals OCF.
Is operating cash flow same as EBIT?
The cash that a company generates from its business operations after deducting capital expenditures is known as free cash flow. Investors can determine if a company has enough cash flow to pay its bills by looking at its operating cash flow.
Is operating cash flow the same as net income?
The cash that a company brings in from its main operations is known as operating cash flow. In most cases, a company’s operating income and net operating income are the same. Even though the two terms occasionally diverge, operating income is frequently referred to as earnings before interest and taxes (EBIT).
