What Does Operating Cash Flow (OCF) Mean?
Operating cash flow is a measure of the cash flow generated by a firm in the course of its normal business operation. It indicates whether the cash flow generated by the firm is sufficient to maintain and grow its operations or whether external financing is required. It can be calculated directly by taking the balance of operating revenue and expense items or indirectly by adjusting the net income for depreciation and changes in working capital.
Divestopedia Explains Operating Cash Flow (OCF)
A company's cash flow will increase or decrease from:
Operating activities: core business
Investing activities: capital expenditure, investments and acquisitions
Financing activities: raising funds and repaying debts
Operating cash flows provide the amount of cash that a firm generates from its core business as opposed to peripheral activities, such as investing and borrowing. It provides a clearer picture of the current reality of the firm's business operations. For example, large sales may not translate into bigger cash flows if accounts receivable are equally large or if there is a huge depreciation of several fixed assets that results in a lower net income.
Operating Cash Flow = EBIT + Depreciation - Taxes
This gives insight into how a firm manages its short-term capital and the amount of cash it generates from revenues, excluding costs associated with long-term investments in capital and securities. A strong OCF implies a stable net income and the ability to weather downturns in the industry. These are highly valued by investors and uncover the true profitability of a firm. Cash flow is harder to manipulate and negative operating cash flows forecast sickness. Chronic earning manipulation can be spotted with the use of operating cash flows.
Many business owners mistakenly interchange the metrics of net income with operating cash flow. The major difference between the two is a company's required investment in working capital. This will have a significant impact on operating cash flows. Take, for example, two companies that have the same level of net income but Company 1 collects its account receivables significantly slower than Company 2. Obviously, Company 1 will have much lower operating cash flows.
Finally, OCF will affect a buyer's assessment of a potential acquisition target. Lower operating cash flows will impact a buyer's ability to service debt obtained for the acquisition and will also reduce investment returns achieved by the acquirer.