Home / What is Operating cash flow? What is the formula and why it is important

What is Operating cash flow? What is the formula and why it is important

What is Operating cash flow? What is the formula and why it is important

What is the Operating Cash Flow (OCF)?     

The Operating Cash Flow (OCF) is a measure of the cash generated from a company’s normal, ongoing business operations. The OCF is an important indicator of the company’s ability to generate and sustain income. It helps investors and financial analysts evaluate the current financial performance and condition of a company by examining the cash flow generated from regular business activities.

It shows how much cash a company is generating from its day-to-day operations. The OCF can help investors identify any potential short-term liquidity issues a company may have, or provide insight into whether the cash generated is sufficient to cover investments in new products or services.

Analysts use Operating Cash Flow (OCF) to get a better understanding of how healthy a company’s operations are and how sustainable its profits may be over time. A company’s OCF can also be used to compare it against similar companies in the same industry.

Why Is It Important For Startups To track the Operating Cash Flow?

Following are the reasons why tracking the operating cash  flow is important for Startups:

1. Operating Cash Flow helps to control expenses:

Tracking the operating cash flow allows Startup owners to monitor and manage their expenditures, as well as identify areas where costs could be reduced or redirected. This can help a startup stay on budget and make sure its resources are used in the most effective manner.

2. It enables better financial planning:

Tracking operating cash flow allows startups to accurately forecast their future financial needs. This information can be used to plan for future expenses, such as expansion or the acquisition of new equipment, and to determine the amount of capital that might need to be raised.

3. It allows better management of taxes:

By understanding its operating cash flow, a startup can plan and make sure that it has sufficient funds available to cover its tax payments. This can help reduce the risk of being hit with late fees or other penalties.

4. It helps to accurately assess startup performance:

Operating cash flow is a key indicator of financial health, providing Startup owners with an accurate picture of their business’s financial strengths and weaknesses. This information can be used to make more informed decisions about the future direction of the business.

5. It allows for better decision-making:

By understanding its operating cash flow, a startup can make informed decisions regarding investments and other expenses. This helps ensure that resources are used in the most efficient manner possible, allowing the startup to achieve its long-term goals.

6. It helps to identify opportunities:

Finally, tracking the operating cash flow allows startups to recognize potential opportunities. This could include new markets or products where the startup can capitalize on its existing strengths or areas in which additional resources should be invested in order to maximize returns.

Overall, understanding and monitoring the operating cash flow is critical for startups to be successful. By tracking this information, startups can better plan for their future, manage their expenses more effectively, and identify potential new opportunities for growth. This knowledge can help ensure that the startup is able to maximize its potential and achieve long-term success.

How To Calculate the Operating Cash Flow?

Here is the formula to calculate the Operating Cash Flow

Let’s assume that the net income is $50,000, depreciation & amortization are $10,000 and the increase in net working capital is $5,000.

The Operating Cash Flow (OCF) will be calculated as follows:

Operating Cash Flow (OCF) = $50,000 + $10,000 – $5,000 = $55,000

Therefore, the Operating Cash Flow for the year is $55,000.

What factors affect the Operating Cash Flow?

The following factors affect the Operating Cash Flow :

1. Revenue:

An organization’s revenue is the major factor influencing its Operating Cash Flow. A rise in revenue increases the Operating Cash Flow and a drop in revenue reduces it.

2. Cost of Goods Sold (COGS):

The cost incurred while manufacturing and selling goods affects the Operating Cash Flow as an increase in COGS reduces the Operating Cash Flow and a reduction in COGS increases it.

3. Overhead Costs:

Overhead costs incurred like rent, utilities, salaries, etc. affect the Operating Cash Flow as an increase in overhead costs reduces the Operating Cash Flow while a decrease increases it.

4. Depreciation:

When an organization depreciates an asset, it reduces its Operating Cash Flow as depreciation is an expense.

5. Investment Activities:

An organization’s investments also affect its Operating Cash Flow. A rise in investment activities increases the cash outflow and decreases the Operating Cash Flow while a decrease in investment activities does the opposite.

6. Financing Activities:

The financing activities of an organization also affect its Operating Cash Flow. A rise in financing activities increases the cash inflow and increases the Operating Cash Flow while a decrease in financing activity reduces it.

7. Tax Payments:

The taxes paid by an organization have a direct effect on its Operating Cash Flow as an increase in tax payment reduces the Operating Cash Flow while a decrease does the opposite.

8. Changes in Working Capital:

The changes in working capital like accounts receivable, inventory, etc. also affect the Operating Cash Flow as a decrease in working capital reduces the Operating Cash Flow while an increase increases it.

These are some of the factors that can significantly impact an organization’s Operating Cash Flow. It is important to have a good understanding of these factors to accurately determine the Operating Cash Flow of an organization.

What is a good Operating Cash Flow?           

A good Operating Cash Flow (OCF) is one that is positive or exceeds expectations. A positive OCF means the company is generating enough cash from its operations to cover its expenses and debts. Companies with high operating cash flows may have more financial flexibility which can help them to grow and expand their businesses.

Additionally, having a healthy may help a company attract more investors and increase its market value. On the other hand, companies with low or negative operating cash flows may be struggling to cover their expenses, which can indicate financial distress or even bankruptcy. It is important for businesses to maintain positive operating cash flow in order to remain financially healthy.

What are examples of Operating Cash Flow?

Suppose a company has the following financials: net income of $40 million, depreciation and amortization of $10 million, and an increase in net working capital of -$5 million.

Using the indirect method, the company’s operating cash flow is calculated as $45 million by adding net income, depreciation, and amortization, and subtracting any increase in net working capital.

To calculate OCF using the direct method, we need to look at cash receipts from customers and cash payments to suppliers and employees. In this example, assume that cash receipts are $80 million, payments to suppliers are -$25 million, and employee wages are -$10 million. The company’s operating cash flow is then calculated as $45 million by subtracting the total payments from total receipts.

Both methods of the calculation result in the same operating cash flow amount, allowing companies to get a comprehensive view of the financial health and performance of their operations.

EXAMPLE 2:

Company A had sales of $1 million, expenses of $500,000, and taxes of $100,000 for the year. However, a quarter of those sales ($250,000) were left unpaid due to customers having 60 days to pay. This means only $750,000 in cash sales was recognized. Consequently, net income and operating cash flow differed greatly:

Net IncomeOperating Cash Flow (OCF)

Sales:       $1,000,000   $750,000

Expenses:-500,000      -500,000

Taxes:      -100,000       -100,000

TOTAL:     $400,000      $150,000

From this, Company A may realize that it needs to speed up the collection of credit sales and/or delay paying some expenses in order to align operating cash flow with net income.

Tips to improve the Operating Cash Flow

The following strategies can help to improve the Operating Cash Flow:

1. Improve Accounts Receivable:

By improving the process of accounts receivable, businesses can reduce their bad debts and get payments faster from clients. This can be done by setting payment terms with clients, using automated invoicing systems, providing discounts for early payments, and implementing credit policies to limit extended payment delays.

2. Reduce Inventory:

By reducing the amount of inventory on hand, businesses can reduce their cash outflows. This can be done by implementing just-in-time ordering systems, having better forecasting practices in place, and avoiding overstocking items.

3. Negotiate Better Supplier Terms:

Negotiating better terms with suppliers is another way to improve the Operating Cash Flow. This can include negotiating longer payment terms and discounts for bulk purchases or early payments.

4. Implement Cost-Cutting Measures:

Cost-cutting measures, such as reducing overhead costs and streamlining processes, can also help to improve the Operating Cash Flow. By becoming more efficient and eliminating expenses that are not necessary, businesses can reduce their cash outflows.

5. Increase Revenue:

Generating more revenue is another way to improve the Operating Cash Flow. This could involve launching new products or services, increasing prices, or diversifying into new markets. By generating more money from sales, businesses will have more money available for operating expenses.

These are some of the strategies that businesses can use to improve their Operating Cash Flow. By implementing these strategies, businesses can ensure their cash flows remain healthy and have enough money available for operations.

Wrap Up

Startups need to know about Operating Cash Flow so they can plan their expenses and make sure they have enough money coming in to cover their bills. By tracking your Operating Cash Flow, you can avoid financial surprises and keep your business running smoothly. Do you have a handle on your startup’s cash flow?

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