Operating Cash Flow
Learn what Operating Cash Flow is and why investors use it to better understand a company's financial health.
What is Operating Cash Flow?
Operating Cash Flow (OCF), also known as Cash Flow from Operations (CFO), is the net amount of cash generated from a company's normal operations during a specific time frame. In simpler terms, OCF will show a financial analyst, how much cash flow arrives from a business's operation, not investments or other income streams for a company.
Operating Cash Flow can be calculated by taking a company’s net income and adding back non-cash expenses and subtracting any increases in working capital.
Operating Cash Flow = Net Income + Non-Cash Expenses - Increase in Operating Working Capital.
The adjustment for non-cash expenses is made because most companies use what’s known as accrual accounting where revenue and expenses on the income statement don’t always line up with the exact cash moving in and out of the business (Think about when a customer purchases something with a credit card, the business records the sale revenue, but the actual cash is collected sometime later).
The adjustment for increases in working capital is made because changes in working capital (think current asset and current liability lines like accounts receivable and accounts payable) affect the true cash inflows and outflows of the company. For example, if a company’s accounts receivables were to increase, that would mean more of its sales (which are currently held in net income) were non-cash sales … or basically we have more customer sales where the company hasn’t received the money yet, hence it being recorded as accounts receivable. This aspect of accounting is why you need to subtract the increase in working capital via accounts receivable to adjust for the real amount of cash flowing into the business.
When to use the Operating Cash Flow?
A company’s operating cash flow for a specific time frame can be highly useful when an investor wants to see if a company can generate positive cash flow and efficiently grow its operations in a timely manner.
A company can produce high profits in the short term, leading investors to believe it was a great investment opportunity when the way the company made a profit wasn’t sustainable.
Therefore, the Operating Cash Flow of a company and its overall cash flow statement can show a business’s true source of income which is linked to how the company grows and operates.
Why Operating Cash Flow is Important
Operating Cash Flow is important to investors because it focuses on a company's main business operations. The OCF concentrates on cash inflows and outflows of a company’s main business activities and not any investing or financing contracts that the company may have made over a certain time period.
Let’s take the company Tesla Inc. for example. Tesla, an all-electric vehicle company generates income from selling its electric vehicles, trucks, Solar Roofs, and other products. We can identify this as Tesla’s core business activity. Tesla also invested more than $2 Billion in Bitcoin and makes much profit from selling carbon credits to other companies. An investor might be more interested in how Tesla is succeeding in its core business activities (vehicle and solar equipment sales), NOT how it’s doing in selling carbon credits and its Bitcoin position, even if it’s profitable.
Ideally, investors are looking for companies with profitable and sustainable core operating businesses. A business may look like a great, high-earning business on the surface, but if an investor figures out that a company has made its temporary fortune off a large one-time sale of its old factory and not from its core operating activities, that investor will likely think twice about the longevity of this businesses. This is why it's really important to understand how to read and calculate a business’s core financial statements. To learn more about how you can level up your finance and valuation knowledge, check out our Complete Finance & Valuation Course!
Example of Calculating Operating Cash Flow
When trying to calculate companies operating cash flow, you will need to find the company’s cash flow statement (one of the three financial statements). Please note this cash flow statement was created exclusively for illustrative purposes and is simplified to be quick and easy for the reader to understand.
Let’s pretend a streaming service company makes fifty million dollars in net income over a twelve-month period.
We can follow the formula previously mentioned to find the operating cash flow. We can add net income ($50 million) and non-cash expenses ($10 million) and then subtract operating working capital ($5 million) which will bring this company’s operating cash flow to $55 million.
That being said, this company only had an increase of $5 million in operating working capital, which is relatively small compared to its $50 million of net income. Investors can see that this streaming service company is able to keep most of its income in real cash when looking at the core business operations.
Want to Learn More about Valuing a Company?
Operating Cash Flow is only part of the valuation process. To learn more about the other sections of the cash flow statement, check out our Cash Flow Statement article that covers the 3 sections of the cash flow statement and how to build a cash flow statement by using a company’s income statement and balance sheet.
We also encourage any business or finance students to check out our Complete Finance & Valuation Course which teaches students the three main valuation methods and the basics of financial accounting and finance. If this article was even the slightest bit interesting, consider looking at the courses and resources we have available.
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