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What Is Operating Cash Flow and How Does It Work?


Operating cash flow, or OCF, refers to the amount of cash a company generates from normal business operations over a specific period of time. It’s widely used to evaluate a company’s performance and prospects. Lenders and investors often consider OCF a better gauge of profitability than indicators such as net income. Here’s what goes into this gauge, two ways it is calculated and why it matters.

What Is Operating Cash Flow (OCF)?

Also referred to as cash flow from operations, OCF is distinct from other financial measures because it focuses on cash generated by a business’s primary operations without including investment, interest or other secondary revenue sources.

Public companies must report OCF in the consolidated cash flow statement included in their annual financial statements. Small privately held companies may also find OCF useful, especially if they generate a significant amount of non-operating income. For instance, the OCF for a retailer that sublets a portion of its shop would subtract out the non-operating rental income to give a better view of how the basic retailing business is doing.

Figuring Operating Cash Flow

There are two ways to calculate operating cash flow. The direct method is simple and gives a basic indicator of OCF. The indirect method is more complicated but may produce a better picture of how a business generates cash from operations.

The Direct Method

In this method, a company will record all transactions on a cash basis and subtract operating expenses incurred by the business’s main activity from total revenue generated by all sources. Operating expenses may include the cost of goods sold, wages, rent, utilities and interest. Total revenue may include money received from non-operating activities, such as gains from investments. Here’s how a restaurant might do a direct OCF calculation.

Revenue – $100,000

Operating expenses:

  • Food costs – $30,000
  • Wages – $20,000
  • Rent – $15,000
  • Utilities – $ 5,000
  • Interest on loans – $5,000

Subtotal of operating expenses – $75,000

Operating Cash Flow – $25,000

Adding the different operating expenses produces a total of $75,000. Subtracting $75,000 from the $100,000 in sales revenue yields an OCF of $25,000 for the year using the direct method.

The Indirect Method

Businessman calculates operating cash flow

This method starts with net income and works backward to obtain a cash basis number. Under the accrual method of accounting, revenue is booked when earned, not necessarily when cash is received. The indirect method is more complicated but, especially with more complex businesses, can give better insight into the activities that generate cash for the business. Public companies have to use the indirect method on their annual cash flow statements.

Indirect OCF calculation starts with net income and then subtracts any gains from non-operating activities, such as investments, and adds back non-cash charges, such as depreciation, amortization and taxes owed but not yet paid. Increases or decreases in accounts receivable, payables and inventory compared to the previous period, if any, are also taken into consideration.

Here’s how a restaurant that had no income from investments might do an indirect OCF calculation:

Net income – $20,000

  • Depreciation – $4,000
  • Amortization – $2,000
  • Deferred taxes – $5,000
  • Increase in accounts receivable – ($5,000)
  • Decrease in inventory – $3,000
  • Decrease in accounts payable – $1,000

Subtotal – $10,000

Operating Cash Flow – $30,000

Adding the $10,000 in subtotaled adjustments to the net income of $20,000 gives $30,000 in OCF for this year. The changes in accounts receivable, inventory and accounts payable could reflect a shifting emphasis on catering during the past year than in previous years. This restaurant’s OCF was higher than its net income, indicating it is efficiently producing cash.

Similar Financial Metrics

OCF is just one of many financial metrics investors, lenders and business owners can use to evaluate business performance. Similar measures include net income, cash flow and free cash flow. Compared to net income, OCF excludes non-operating revenues and paper accounting costs. Cash flow also may include revenue from other sources such as borrowing that are not part of OCF. Free cash flow removes from the equation capital expenses for real estate, machinery, equipment and the like.

Different accounting techniques can produce different net income figures. Borrowing can keep cash flow high enough to pay bills. Delaying capital investments can boost free cash flow. Improving OCF, on the other hand, requires some combination of increasing revenues, speeding customer collections, slowing creditor payments and cutting interest costs, all arguably more fundamental improvements to a business’s health and prospects.

The Bottom Line

Owner of a small grocery storeBecause of its focus on cash generated by core operations, OCF is considered an important financial measure for business owners, investors and financiers. Public companies are required to report OCF as part of their annual financial statements. Private companies making a case to lenders about their efficiency and prospects often use OCF data as evidence.

Tips for Analyzing Businesses

  • Consider working with an experienced financial advisor if you are calculating operating cash flow or evaluating the OCF of a company for potential investment. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goalsget started now.
  • Besides OCF, it’s important to understand income statements and balance sheets if you’re going to make an informed decision about whether to invest in a business.

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