What Is Operating Cash Flow (OCF): Definition and Formula - Shopify Canada (2024)

Your business has been profitable for the past two years, yet you sometimes have trouble paying all the bills on time. What’s going on?

After some review and examination, you see sales have been growing, but collections are lagging—more customers are taking longer to pay, even as you pay your suppliers and vendors promptly. That means the business, even if it’s profitable, sometimes has a cash crunch or some problems with its operating cash flow.

What is operating cash flow?

Operating cash flow is an accounting measure that tracks the amount of money received and paid by a company. It’s an essential way to gauge a company’s ability to generate enough cash to operate without the need for outside financing from loans, bonds, or stock offerings. In other words, operating cash flow is more about a company’s liquidity than its profitability.

How to calculate operating cash flow

There are two main ways to calculate operating cash flow: the direct method and the indirect method. Most businesses prefer the indirect method because it allows them to reconcile their income statement with their cash-flow statement and to account for differences between the two. It shows the interplay between profitability and cash flow.

Indirect method

The indirect method starts with a business’s income statement. It then adds back any noncash charges, such as depreciation and amortization of assets (depreciation is for tangible assets, amortization is for intangible). Then any year-to-year change in net working capital, from the balance sheet, must be included. The indirect formula is:

OCF = net income + depreciation and amortization - change in working capital

Net working capital is a business’s total current assets minus current liabilities. These are amounts received or paid during a company’s current business cycle, which is typically one year.

Current assets include things such as inventory (unsold goods) and accounts receivable, and current liabilities include accounts payable, short-term debt, and taxes due.

Net working capital is how much money a business has available to pay short-term expenses, or those coming due within the current year. It is tracked from year to year to see if it has increased or decreased. An increase represents a net reduction in cash because more cash was spent to buy current assets such as inventory. A decrease in net working capital means the opposite.

Direct method

The direct method tracks only cash transactions in a given period. Cash income includes money collected from customers, and interest or dividends received. Cash payments include wages and salaries, payments to suppliers, and interest and taxes paid. The direct formula is:

OCF = cash sales or revenue received - cash paid for operating expenses

Example of operating cash flow

As an example of how credit sales can affect operating cash flow, let’s say Company A reports $1 million in sales, $500,000 in expenses, and $100,000 in taxes for the year. A quarter of those sales, $250,000, aren’t yet collected, because customers have 60 days to pay, so only $750,000 in cash sales are recognized. Here is how net income and operating cash flow would compare for the year:

After comparing these, Company A might conclude it needs to collect faster on credit sales, or perhaps delay paying some of its expenses, to bring operating cash flow more in line with net income.

Operating cash flow vs. net income

Businesses evaluate operating cash flow alongside net income to see if profitability and cash generation are moving in the same direction (presumably upward), or if they are diverging—and to understand why.

Operating cash flow and net income might seem like the same thing—both are concerned with tracking the movement of money. The key distinction between operating cash flow and net income (profit) is the accounting methods used for income and expenses. Net income uses the accrual method, which records sales and expenses when transactions or production occur, even if cash wasn’t received or paid. This means some items in a company income statement can be noncash. Operating cash flow counts only cash as it’s received or paid out.

How are they similar?

Each is an essential measure of a business’s financial health. Net income gauges strength based on profitability, while operating cash flow is more concerned with liquidity—the day-to-day ability of the business to pay recurring expenses from sales or revenue.

How are they different?

Although both measures gauge a company’s financial condition, there are important differences.

• Net income is based on the accrual method of accounting, which makes assumptions about the timing of some income and expenses, regardless of when money is received or paid in the financial year.
• Operating cash flow uses cash accounting, which tracks only actual receipts and payments of money in the financial year.

A company’s operating cash flow can be more or less than its net income, depending on its circ*mstances. Slower collections from customers at one company might be the cause of cash flow lagging behind profit, while at another company with large depreciation charges, operating cash flow might exceed net income.