Operating Cash Flow shows how much cash flow is being generated by the company from the core business operations without taking into consideration the cash from secondary sources of revenue. It thus, helps to analyse how efficiently a business is producing cash from its principal business activity.
Operating cash flow indicates the health of a company. A company having huge cash inflows from streams like interest, sale of assets, extraordinary activities apart from their core business activities will be termed as unhealthy as this is not sustainable over a long period of time.
There are two ways to obtain the Operating Cash Flows – Direct method and Indirect Method. Companies usually use the indirect method of calculation of operating cash flows in their quarterly reports and annual cash flow statement. This can be derived by using the formula:
Operating Cash Flow = Net Profit + Non-cash Expenses +/- Changes in Assets and Liabilities
This formula gives us a better insight on the company’s operations. It helps in converting the accrual income (P&L) statement to cash basis, based on the operations of the company.
The direct method of computing the operating cash flow simply subtracts the operating expenses from total revenue. This formula doesn’t give investors much insight of the operations, or from where cash is actually generated / discharged in the business operations. The formula for direct method is:
Operating Cash Flow = Revenue - Operating Expenses
Let’s take an example of a Company say ABC Ltd. whose year-end financials show the following figures:
- Net Income: Rs. 1,00,000
- Depreciation: Rs. 20,000
- Change in inventory: + Rs. 40,000
- Change in Accounts Receivable: + Rs. 10,000
- Change in Accounts Payable: - Rs. 30,000
Now, using the indirect method, calculating Operating Cash Flow for ABC Ltd.
Operating Cash Flow = 1,00,000 + 20,000 - 40,000 - 10,000 - 30,000
= Rs. 40,000
Thus, ABC Ltd. generated a cash flow of Rs. 40,000 for the given period, which can be interpreted as follows - Even when net income of ABC Ltd. was Rs. 1,00,000, cash generated from operations was only Rs. 40,000. This scenario arises due ABC Ltd.’s inability to collect receivables on time and paying off creditors before that.
Thus, one may conclude that the operating cash flows are difficult to be manipulated and are better indicators of a company’s financial position.