A Detailed Guide on Operating Cash Flow

Every company periodically reviews its performance to assess whether it is moving in the right direction as per its objectives. Calculating operating cash flow is an efficient way to gauge its core fundamentals and understand its financial health. To know more about OCF, keep reading!

 

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What is an Operating Cash Flow Statement?

 

OCF tracks cash inflows and outflows of a company during its normal operations. Investors and analysts monitor whether the company is generating positive cash flows. This will help them to self-finance their growth and expansion prospects. On the other hand, if the company generates negative cash flow, they have to take assistance from a few external sources. 

Companies use net income, non-cash expenses, and changes in working capital to prepare a detailed operating cash flow statement. 

 

How to Prepare OCF Statement?

 

There are two ways of preparing a cash flow statement which are as follows:

 

  • Direct method.

 

It is the simplest way of preparing a cash flow statement from operating activities. This report provides accurate results. The formula for preparing an operating cash flow statement using the direct method is Total Revenues – Operating Expenses. 

However, it fails to gauge the true picture of a company’s financial health. As a result, investors and companies do not get any meaningful insights by looking at OCF prepared using the direct method.

 

  • Indirect method

 

Under this method of preparing an operating cash flow, companies adjust their net income with non-cash items to reflect changes occurring in the balance sheet. These non-cash items include amortization, depreciation, accounts receivables, accounts payable, etc. 

Moreover, companies also adjust their net income with changes occurring in the working capital. Companies maintain their accounts on an accrual basis. So, these adjustments are necessary to reflect the true nature of cash transactions on the company’s financials.

For example, in the case of accounts receivable, let’s say that a company books a sum to be received on an accrual basis, but the actual payment has not been received. While preparing OCF, they must deduct AR or accounts receivable from the net income to show the actual cash position.

Similarly, in the case of accounts payable, the company reports an expense on an accrual basis. However, actual payments have not been made. Therefore, the organization will have to add this to the net income to show the actual cash position. 

 

Operating cash flow formula using indirect method = (Net Income +/- Changes in Asset and Liabilities + Non-cash Expenses)

 

Example of OCF Using Indirect Method

 

Shivaji Capitals has the following financial indicators for 2021-22

Net Income = Rs. 5,00,000

Depreciation = Rs. 15,000

Accounts receivable = Rs. 1,02,000

Accounts Payable = Rs. 97,000

Inventory changes = Rs. 35,000

 

OCF = Net Income (+/-) Change in asset and liability + Non-cash expenses

Rs. (5,00,000 + 97,000 + 15,000 – 1,02,000 – 35,000) = Rs. 4,75,000    

 

Importance of OCF Statement

 

 OCF is an important aspect because of these reasons:

 

  • Indicator to investors

 

If OCF is positive or negative, it sends an important signal to investors about the company’s health. A positive cash flow means that the company has an adequate cash balance, and it can go for expansion or growth using its funds.

Conversely, a negative cash flow means that the company lacks sufficient cash balances and may not be able to finance its activities by itself. 

 

  • Company’s performance

 

Any investor will be able to make an informed decision by looking at the operating cash flow statement. 

 

  • Cash sources

 

One will get to know the true measure of cash transactions. It enhances transparency in the company’s operations. 

 

Types of Cash Flow Statements

 

Here are the three types of cash flow statements:

 

  • Operating cash flow

 

This statement reflects the company’s cash position during its normal course of operation. A company prepares OCF for a specific time frame and reviews its position by considering the findings of the statement. 

 

  • Cash flow from investing activities

 

This tracks all investment transactions and activities occurring within and outside the company. It includes all capital assets bought and sold by the company within a timeframe. Outstanding and repaid loans also form a part of cash flow from investing activities. Any investment that a company makes in other ventures finds a place in the statement. 

 

  • Cash flow from financing activities

 

All proceeds that a company receives from its debt and equity instruments are shown in cash flow from financing activities. All payments that a company makes, like dividends and interest, also form a part of this. 

 

Difference Between Operating Cash Flow and Net Income

 

Here are the differences between the operating cash flow and net income:

 

 

Parameter OCF Net Income
Meaning It reflects a company’s cash position based on its operations. Net income reflects the total income that a company earns during a period.
Importance This helps to exhibit the true financial position of the company. NI or net income is a prerequisite for preparing an OCF statement.
Reliability It is a credible and reliable statement providing valuable insights.  It is not entirely accurate as there is room for manipulating these figures.
Indicator OCF statement shows the capability of a company to pay off its debts, particularly in the short term. It plays an integral part in establishing the valuation of the company.

 

 

Final Word

 

Operating cash flow is one of the most important statements for a company. It acts as a guide for both investors and companies who can make appropriate decisions based on the report’s findings. Investors should keep a check on this OCF as it may also influence the stock price.

 

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