Operating cash flow (OCF) is an important tool used in the CPM process to monitor liquidity. Cash flow management is important to many businesses and as such, it is important to understand how operating cash flow is impacted by net income. Operating cash flow is represented in the statement of cash flows and is the first section before cash flows from investments and cash flows from financing. 

In this FAQ we will discuss what operating cash flow is, why it is important, and the methods for calculating operating cash flow. 

What Is Operating Cash Flow?

Operating cash flow is the amount of cash generated throughout the normal course of operations. It is an indicator as to how well the business is able to create and maintain sufficient cash flows. Operating cash flow is reconciled to operating activities, which are the primary revenue-generating activities of a business. 

Cash flows from operations is the first section in the statement of cash flows, which is one of the three primary financial statements. In the statement of cash flows, operating net income is reconciled to cash by adding back and subtracting the various cash impacts of operating activities. 

Why Is Operating Cash Flow Important? 

Generating sufficient cash flow to continue normal operations is critical. Operating cash flow is an indicator as to how well the business can generate cash balances to cover its expenses. If the business does not have sufficient operating cash flow it might not be a going concern. 

That is not to say that negative operating cash flow is bad, but rather it is an indicator that some external source of cash is required, either through outside investment in the business or through financing. This is why it is presented alongside cash flow from investing and financing on the statement of cash flows. 

The comprehensive picture presented on the statement of cash flows helps FP&A analysts to identify how sustainable the business is, how liquid its operations are, and whether or not its current activities are being carried out in a manner that requires attention. 

Understanding operating cash flow is important because it is a clear measure of how well the business can generate profit sufficiently. It is representative of how much excess cash the business is capable of generating. This information is then used by decision-makers to determine whether the business has the necessary capital to grow or if it requires external financing to continue its growth trajectory. 

Analysts usually refer to operating cash flow metrics because it helps to reduce the noise created by accounting policies and procedures. It provides a clear picture of how well the business can translate net income to cash. 

How To Calculate Operating Cash Flow

There are two primary methods of calculating operating cash flow: the indirect method and the direct method. Both are adequate, but the indirect method is more commonly used by financial analysts when access to transactional data is limited. Understanding the two methods will help to determine the best approach for your needs. 

The Direct Method

The direct method can be used when a business records its transactions on a cash basis. While this is typically not the case, some businesses do report their financials using the cash basis of accounting. In this method, all transactions are recorded using actual cash in and out. 

The result of recording transactions based on their cash value is that the values listed in the income statement are representative of actual cash receipts and payments. This makes interpreting the information and relating it to the income statement much easier and faster. However, most businesses choose to report under the accrual basis of accounting and publicly traded companies typically required to. In these cases, the indirect method should be used. 

The Indirect Method

Using the indirect method is the most common way of representing operating cash flow. This is done by taking the accrual basis net income for the period and adjusting it to reflect the operating cash flow for the period. Under the accrual method of accounting, revenue and expenses are recorded in the period they incur, which results in revenue and expenses being recorded in periods that do not necessarily coincide with cash receipts and payments. 

On the statement of cash flows, the first value is net income from the income statement. This amount is followed by the adjustments needed to reconcile net income to operating cash flows. Typically, net income is adjusted for depreciation and amortization, expenses related to asset impairment, changes in working capital, changes in cash provisions, interest, and taxes. 

Using Datarails, a Budgeting and Forecasting Solution

Datarails’ FP&A solution replaces spreadsheets with real-time data and integrates fragmented workbooks and data sources into one centralized location. This allows users to work in the comfort of Microsoft Excel with the support of a much more sophisticated data management system at their disposal. 

Every finance department knows how tedious building a budget and forecast can be. Integrating cash flow forecasts with real-time data and up-to-date budgets is a powerful tool that makes forecasting cash easier, more efficient, and shifts the focus to cash analytics. 

Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.

Datarails is an enhanced data management tool that can help your team create and monitor cash flow against budgets faster and more accurately than ever before.