Two Methods of Presenting OCF
There are two methods of presenting OCF. The indirect method and the direct method.
Indirect
The indirect method uses more roundabout ways to find the value of the OCF. To utilize the indirect method, a company will begin by achieving a net income value on an accrual basis of accounting. They then work backwards to get a cash basis figure using the net income. With the accrual method of accounting, revenue is recognized when earned, not necessarily when cash is received. The use of this approach also affects the balance sheet, as receivables or payables might be recorded with the absence of a cash receipt or cash payment, respectively.
As an example, consider a music retail store that specializes in selling keyboards and pianos. As Amazon depletes their customer base for their keyboard purchases, the owner needs to analyze their year-end financial statements to confirm that the business is still earning a profit and can continue operating as-is. If there is not enough positive cash flow, they will have to consider additional financing or make cuts to their budget.
To highlight how the value of the OCF would be calculated, let’s imagine one of their statements:
- Net Income: $50,000
- Depreciation Expense: $5,000
- Change in accounts receivables: +$25,000
- Change in accounts payable: -$12,500
- Change in inventory: -$10,000
Using the indirect method, the formula to calculate the OCF would look like this:
$27,500 = $50,000 - $25,000 + $10,000 - $12,500 + $5,000
The piano shop is able to generate $27,500 of cash flows from its current operations. That value means the operations generated enough money to pay the bills and have $27,500 left over at the end of the year. Using this number, the owner of the shop will be able to make sound financial decisions to prepare for the upcoming year.
Direct
For the direct method, a company will record all transactions on a cash basis and then display that information using actual cash inflows and outflows during the accounting period.
Examples of reporting operating cash flow via the direct method include:
- Interest paid and income tax paid
- Cash received from customers
- Cash paid to vendors and suppliers
- Interest income and dividends received
- Paid salaries
The OCF Formula
All publicly traded firms must calculate their operating cash flows using the indirect method based on the accrual method of accounting. Net income will be adjusted to a cash basis using changes in non-cash accounts, such as accounts receivable (AR), accounts payable (AP), and depreciation and amortization (compensation which is based upon stock shares).
Put into a simple formula, the calculation looks like this:
Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital
A more complex formula looks like this:
Operating Cash Flow = Net Income + Depreciation + Stock Based Compensation + Deferred Tax + Other Non Cash Items – Increase in Accounts Receivable – Increase in Inventory + Increase in Accounts Payable + Increase in Accrued Expenses + Increase in Deferred Revenue
There may be additional non-cash items or changes in current liabilities or assets that are not noted in the formula above. Ensure all items are accounted for based on the pertinent business being analyzed.
If the company is using the direct method, the formula simply looks like this:
Operating Cash Flow = Total Revenue - Operating Expenses
Why is OCF Important?
When analyzing a balance sheet, many financial analysts, creditors, and investors prefer to look at the OCF metric. It is a precise measurement of cash flows, avoiding numbers that can be confusing due to hidden and complicated accounting tricks.
When performing financial analysis for a company, it is essential to look at operating cash flow alongside other metrics, net income, free cash flow (FCF), and more. Combining those metrics will allow the analyst to assess a company’s financial health and performance correctly.
Net Income and Operating Cash Flow
Net income is one of the most frequently referenced financial metrics, but how is it different from operating cash flow? By digging down into accounting rules used when preparing financial statements — such as the matching principle and accrual principle — the differences in the two metrics become apparent.
Net income is a calculation including various expenses; some that have already been paid for and some that accounting principles (like depreciation) might have created. Also, a company’s revenue recognition principle and matching expenses to the timing of revenues may cause a material difference between net income and OCF.
When calculating net income, it is essential to remember that any accounts receivable increases are considered booked revenues because no collections have been completed. Therefore, these increases are taken off of the net income value.
Basically, net income measures whether or not a company made money during a specified period--it does not tell you when those inflows and outflows of cash are occurring. This fact alone makes the operating cash flow the better indicator of a business’s day-to-day financial health.
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Sources:
- What is Operating Cash Flow (OCF)? – Herold Financial Dictionary
- Accrual basis of accounting definition — AccountingTools
- Why Small Businesses Fail Infographic | Business Insider
