How to calculate ocf in finance?

Operating Cash Flow (OCF) is the amount of cash generated by the regular operating activities of a business within a specific time period. OCF begins with net income (from the bottom of the income statement), adds back any non-cash items, and adjusts for changes in net working capital, to arrive at the total cash generated or consumed in the period.

When performing financial analysis, operating cash flow should be used in conjunction with net income, free cash flow (FCF), and other metrics to properly assess a company’s performance and financial health.

Below is an example of operating cash flow (OCF) using Amazon’s 2017 annual report. As you can see, the consolidated statement of cash flows is organized into three distinct sections, with operating activities at the top, then investing activities, and finally, financing activities. In addition to those three sections, the statement also shows the starting cash balance, total change for the period, and ending balance.

Let’s analyze how the operating section works:

Source: amazon.com

Image: CFI’s Advanced Modeling Course – Amazon Case Study.

At the bottom of the operating cash flow section, we can see the total, which is labeled as “Net cash provided by (used in) operating activities.” The line is the sum of all items above it and represents the total for the period.

Whether you’re an accountant, a financial analyst, or a private investor, it’s important to know how to calculate how much cash flow was generated in a period. We may sometimes take for granted when reading financial statements how many steps are actually involved in the calculation.

Let’s analyze the operating cash flow formula and each of the various components.

Formula (short form):

Formula (long form):

The formulas above are meant to give you an idea of how to perform the calculation on your own, however, they are not entirely exhaustive. There can be additional non-cash items and additional changes in current assets or current liabilities that are not listed above. The key is to ensure that all items are accounted for, and this will vary from company to company.

Net income and earnings per share (EPS) are two of the most frequently referenced financial metrics, so how are they different from operating cash flow? The main difference comes down to accounting rules such as the matching principle and accrual principle when preparing financial statements.

Net income includes all sorts of expenses, some that may have actually been paid for and some that may have simply been created by accounting principles (such as depreciation).

In addition, a company’s revenue recognition principle and matching of expenses to the timing of revenues can result in a material difference between OCF and net income.

Unfortunately, it is not possible to simply say that one number is always higher or lower than the other. Sometimes OCF is higher than net income (as with Amazon, shown above) and sometimes it’s the opposite.

Source: Amazon.com

Image: CFI’s Advanced Modeling Course – Amazon Case Study.

As you can see in the screenshot above, there is a major difference between the two metrics, and Amazon has constantly generated more OCF than net income. To be fair though, what OCF doesn’t take into account is capital expenditures (CapEx) or purchases of PP&E. By deducting CapEx from OCF you arrive at Free Cash Flow, which is a better assessment of available cash generated for the period.

Calculating the cash flow from operations can be one of the most challenging parts of financial modeling in Excel. Below is an example of what this activity looks like in a spreadsheet.

As you can see in the screenshot, there are various adjustments to items necessary to reconcile net income to net cash from operating activities, as well as changes in operating assets and liabilities. In a financial model, there are separate sections for the depreciation schedule and working capital schedule, which then feed into the cash flow statement section of the model. The example below is taken from CFI’s Amazon Case Study Course.

Image: CFI’s Advanced Amazon Modeling Course.

As you can see in the above example, there is a lot of detail required to model the operating activities section, and many of those line items require their own supporting schedules in the financial model.

Below is a short video tutorial explaining how the three sections of a cash flow statement work, including operating activities, investment activities, and financing activities.

Operating cash flow, represented on the cash flow statement, refers to the income that flows in and out of a business due to its operational income and expenses.

Learn how operating cash flow works, how it is used, and how you can calculate taxes from it.

Cash flow refers to the way in which money flows into and out of a business, and operating cash flow is cash flow that is connected with operating activities.

Operating cash flow is useful for helping executives track their business’s financial health so they can make decisions on how it will operate. Management can determine whether the business can afford its expenses, and whether they need to make changes. Cash flow is also used to prove a business’s creditworthiness to lenders and investors.

Operating cash flow refers to the money that goes in and out of a business due to income and expenses related to its operations.

Operating expenses are normal expenses required to run the business, such as payroll and costs of materials to manufacture products. A positive operating cash flow helps ensure the business can afford to continue its operational duties and grow. Otherwise, it may need financing.

The operating cash flow of a business can be calculated using the following formula:

Operating Cash Flow = EBIT + Depreciation – Taxes

EBIT refers to the earnings before interest and taxes. This is the amount the business made from its revenue minus the operating expenses. To determine the operating cash flow, the business must track its depreciation of assets used for operations and add this amount to its EBIT. After this has been calculated, it must deduct the amount of taxes owed to reach the operating cash flow.

For example, if a business earned $500,000 in revenue and incurred operating expenses consisting of salaries, materials, and equipment of $400,000, then the $400,000 is deducted from the $500,000 to find the EBIT, which is $100,000.

If depreciation was $60,000, but taxes owed were $75,000, the operating cash flow calculation would be:

Operating Cash Flow = $100,000 + $60,000 - $75,000

So, the company would have $85,000 of operating cash flow.

Typically, a business calculates its taxes due by multiplying the tax rate by the amount of taxable income made by the business. By analyzing the operating cash flow equation, a business can determine how tax is impacting the amount of cash flowing into the business.

Cash flow analysis has its limitations when it comes to determining the value and success of a business.

A cash flow statement only looks at the income and expenses that flow in and out of a business. It doesn’t include other assets of the business that can bring value, such as equipment and intellectual property. It doesn’t account for any other factors that could impact its growth, such as intangible assets like reputation and customer base, nor does it reflect whether the money flowing comes from a loan.

Cash flow is not the only indication of its potential growth and development. Metrics on other financial statements such as the income statement and the balance sheet also provide key information.

Keep in mind that cash flow is not the same as profitability, which is another key indicator of a business’s financial strength. They are separate metrics showing different perspectives of the business. A business can have a positive cash flow but not profit, or it can generate a good profit and still have a negative cash flow.

Cash flow analysis is used for a variety of reasons because it provides insight to the financial health of the business. Operating cash flow is specific to the activities having to do with the operations of the business. Understanding how to use the operating cash flow equation to determine how taxes are impacting the cash inflow can help business executives make financial decisions.

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Operating cash flow (OCF) is a measure of the amount of cash generated by a company's normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion.

Operating cash flow represents the cash impact of a company's net income (NI) from its primary business activities. Operating cash flow—also referred to as cash flow from operating activities—is the first section presented on the cash flow statement.

Two methods of presenting the operating cash flow section are acceptable under generally accepted accounting principles (GAAP)—the indirect method or the direct method. However, if the direct method is used, the company must still perform a separate reconciliation to the indirect method.

Operating cash flows concentrate on cash inflows and outflows related to a company's main business activities, such as selling and purchasing inventory, providing services, and paying salaries. Any investing and financing transactions are excluded from the operating cash flows section and reported separately, such as borrowing, buying capital equipment, and making dividend payments. Operating cash flow can be found on a company's statement of cash flows, which is broken down into cash flows from operations, investing, and financing.

Using the indirect method, net income is adjusted to a cash basis using changes in non-cash accounts, such as depreciation, accounts receivable (AR), and accounts payable (AP). Because most companies report the net income on an accrual basis, it includes various non-cash items, such as depreciation and amortization.

The calculation for OCF using the indirect method uses the following formula:

OCF = NI + D&A - NWC

Where NI represents the company's net income, D&A represents depreciation and amortization, and NWC is the increase in net working capital.

Net income must also be adjusted for changes in working capital accounts on the company's balance sheet. For example, an increase in AR indicates that revenue was earned and reported in net income on an accrual basis although cash has not been received. This increase in AR must be subtracted from net income to find the true cash impact of the transactions.

Conversely, an increase in AP indicates that expenses were incurred and booked on an accrual basis that has not yet been paid. This increase in AP would need to be added back to net income to find the true cash impact.

Consider a manufacturing company that reports a net income of $100 million, while its operating cash flow is $150 million. The difference results from a depreciation expense of $150 million, an increase in accounts receivable of $50 million, and a decrease in accounts payable of $50 million. It would appear on the operating cash flow section of the cash flow statement in this manner:

Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital.

Arming yourself with a little accounting know-how can keep you in control of your business finances, making sure you stay profitable in the short- and long-term.

Today, we’re going over operating cash flow. What is operating cash flow, and why is it important for your business? Then we’ll go over how to calculate operating cash flow using the formula and an example to help you through. Check it out:

Operating cash flow is the part of the cash flow statement that shows how much money a business earns from typical operations. It’s calculated as revenue minus operating expenses. Operating cash flow represents a company’s overall ability to turn a profit. Negative operating cash flow means businesses might need to secure additional funding in order to keep the wheels turning.

Normal business operations include things like providing services, payroll, marketing and advertising, and similar activities necessary to carrying out your business. Operating cash flow does not account for things like investments or interest.

Operating cash flow is also known as OCF, cash flow provided by operations, cash flow from operating activities, and free cash flow from operations.

OCF is different from free cash flow (FCF) because FCF accounts for capital expenditures (CAPEX), while OCF does not.

Generally speaking, you want to aim for a higher OCF. This will mean that you’re increasing capital without the need for investments or funding.

It’s important to keep an eye on OCF over time, too. The metrics should trend upward, indicating an increase in profitability.

Operating cash flow is not the same as net income. First, let’s look at basic definitions of each:

More specifically, net income (or net earnings), is total sales minus the cost of goods sold, associated expenses, operating expenses, depreciation, interest, taxes, and any other costs. Net income gives a more comprehensive look at the overall profitability in terms of the value of your business, while OCF looks at profitability in terms of capital you can physically use in your business.

OCF indicates how self-sustainable a business is in terms of generating an ongoing profit relying solely on standard business operations.

This is important from a few perspectives:

The most important perspective of all is the business owner. It’s important that you’re in tune with your business’s ability to generate a profit on its own. Track this metric over time so you can see when your business is becoming more or less profitable and then dig into why.

As we mentioned before, OCF is revenue minus operating expenses. The simplest formula goes like this:

Operating cash flow = total cash received for sales - cash paid for operating expenses

The OCF formula is also written out in other ways, with different terms:

OCF = (revenue - operating expenses) + depreciation - income taxes - change in working capital

OCF = net income + depreciation - change in working capital

OCF = net income - changes in working capital + non-cash expenses

Essentially, you want to adjust for things like depreciation, increases in accounts receivable, and other non-cash and non-operating expenditures from your net income.

It’s important to use data from the same accounting period — otherwise, you risk inaccurate results.

Now let’s look at an example to put this all into perspective.

Here’s the scenario: You have a small event planning business. Your cash came from invoicing customers a total of $100,000 for the fiscal year. During that same period, you spent $5,000 in operating expenses: things like membership subscriptions, professional development training, and social media ads.

You also own a company vehicle, which you use to drive to and from event venues, suppliers, clients’ homes, etc. You estimate that it depreciated $3,000 during that same year.

Come tax time, you ended up paying $25,000. Your net income = $100,000 - $5,000 - $3,000 - $25,000, coming in at $67,000.

So, to calculate your OCF, we’ll plug in the formula as follows:

OCF = net income + depreciation

OCF = $67,000 + $3,000

OCF = $70,000

While you could *technically* say you earned six figures that year, you really only turned a profit of $67,000 and your OCF was $70,000 — a more realistic number representative of the state of your business.