Operating cash flow (OCF) is cash generated from normal operations of a business. As part of the Cash Flow Statement the cash flows of the operating activities, investing activities, and financing activities are segregated so the analyst can get a clear picture of the cash flows of all the company’s activities.
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Operating cash flow is important because it provides the analyst insight into the health of the core business or operations of the company. Without a positive cash flow from operations a company cannot remain solvent in the long run. A negative operating cash flow would mean the company could not continue to pay its bills without borrowing money (financing activity) or raising additional capital (investment activity).
Operating Cash Flow Calculation
Operating Cash Flow (OCF) = Operating Income (revenue – cost of sales) + Depreciation – Taxes +/- Change in Working Capital
The Operating Cash Flow Calculation is operating income before depreciation minus taxes and adjusted for changes in working capital. Financing activities (dividends, issuance/purchase of common stock, issuance/purchase of debt securities) and investing activities (i.e. capital expenditures (CAPEX), acquisitions) are excluded or separate from the Operating Cash Flow calculation.
Note: Working capital is current assets minus current liabilities on the balance sheet. This is the amount of money it takes to run the operations of the business. Examples of working capital items are inventories, accounts receivable and payable, and cash.
Purpose of Operating Cash Flow
Financing and investment activities are excluded because the purpose of the operating cash flow is to segregate and evaluate the health of the normal operations or core business. The business entity produces a product or service, and the analyst wants to know if the core business produces sufficient cash flow to 1) pay its operating expenses; and 2) provide capital for future growth (investment activities); 3) meet the entity’s interest and debt requirement, and pay dividends or repurchase shares from stakeholders (financing activities).
Cash flow is a better metric than profits for evaluating the health of a company’s operations because accounting earnings are affected by non-cash items such as depreciation or amortization. In other words, capital intensive companies would be apt to have large non-cash depreciation expenses that would lower earnings. Therefore cash flow provides a more accurate metric than accounting earnings for evaluating the true contribution or worth of core business operations.
The Cash Flow Statement provides the cash flow of the operating, investing, and financing activities to disclose the entire cash flow in a consolidated statement. The Operating Cash Flow Calculation will provide the analyst with the most important metric for evaluating the health of a company’s core business operations.
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