Operating Cash Flow

Cash generated from operating activities of a business

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What is Operating Cash Flow?

Operating Cash Flow (OCF) is the amount of cash generated by the regular operating activities of a business within a specific time period. OCF begins with net income (from the bottom of the income statement), adds back any non-cash items, and adjusts for changes in net working capital, to arrive at the total cash generated or consumed in the period.

When performing financial analysis, operating cash flow should be used in conjunction with net income, free cash flow (FCF), and other metrics to properly assess a company’s performance and financial health.

Operating Cash Flow Formula and Diagram

Operating Cash Flow Example

Below is an example of operating cash flow (OCF) using Amazon’s 2017 annual report. As you can see, the consolidated statement of cash flows is organized into three distinct sections, with operating activities at the top, then investing activities, and finally, financing activities. In addition to those three sections, the statement also shows the starting cash balance, total change for the period, and ending balance.

Let’s analyze how the operating section works:

  • Net income from the bottom of the income statement is used as the starting point
  • All non-cash items are “added back”, meaning any accruals are reversed, including:
    • Depreciation, which is an accounting method for expensing property, plant, and equipment (PP&E) purchases
    • Stock-based compensation is not paid out with actual cash, but instead with the issuance of shares
    • Other expense/income could include various items such as unrealized gains or losses or accrued items
    • Deferred taxes arise from the difference between accounting methods companies use when filing their taxes vs those needed for filing their financial statements
  • Change in working capital (operating assets and liabilities) adjustments include:
    • When inventory on the balance sheet goes up, it results in a reduction of cash
    • When accounts receivable increases, it also creates a reduction of cash, as it means a portion of the revenues recorded have not yet been paid by customers
    • When accounts payable, accrued expenses, and unearned revenue increase, they cause an increase in cash

Amazon's Operating Cash Flow Example
Source: amazon.com

Image: CFI’s Advanced Modeling Course – Amazon Case Study.

At the bottom of the operating cash flow section, we can see the total, which is labeled as “Net cash provided by (used in) operating activities.” The line is the sum of all items above it and represents the total for the period.

Operating Cash Flow Formula

Whether you’re an accountant, a financial analyst, or a private investor, it’s important to know how to calculate how much cash flow was generated in a period. We may sometimes take for granted when reading financial statements how many steps are actually involved in the calculation.

Let’s analyze the operating cash flow formula and each of the various components.

Formula (short form): 

Operating Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital

Formula (long form):

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

The formulas above are meant to give you an idea of how to perform the calculation on your own, however, they are not entirely exhaustive. There can be additional non-cash items and additional changes in current assets or current liabilities that are not listed above. The key is to ensure that all items are accounted for, and this will vary from company to company.

Operating Cash Flow vs Net Income

Net income and earnings per share (EPS) are two of the most frequently referenced financial metrics, so how are they different from operating cash flow? The main difference comes down to accounting rules such as the matching principle and accrual principle when preparing financial statements.

Net income includes all sorts of expenses, some that may have actually been paid for and some that may have simply been created by accounting principles (such as depreciation).

In addition, a company’s revenue recognition principle and matching of expenses to the timing of revenues can result in a material difference between OCF and net income.

Unfortunately, it is not possible to simply say that one number is always higher or lower than the other. Sometimes OCF is higher than net income (as with Amazon, shown above) and sometimes it’s the opposite.

Net Income vs Operating Cash Flow - Amazon
Source: Amazon.com

Image: CFI’s Advanced Modeling Course – Amazon Case Study.

As you can see in the screenshot above, there is a major difference between the two metrics, and Amazon has constantly generated more OCF than net income. To be fair though, what OCF doesn’t take into account is capital expenditures (CapEx) or purchases of PP&E. By deducting CapEx from OCF you arrive at Free Cash Flow, which is a better assessment of available cash generated for the period.

Operating Cash Flow in Financial Modeling

Calculating the cash flow from operations can be one of the most challenging parts of financial modeling in Excel. Below is an example of what this activity looks like in a spreadsheet.

As you can see in the screenshot, there are various adjustments to items necessary to reconcile net income to net cash from operating activities, as well as changes in operating assets and liabilities. In a financial model, there are separate sections for the depreciation schedule and working capital schedule, which then feed into the cash flow statement section of the model. The example below is taken from CFI’s Amazon Case Study Course.

Example of Operating Cash Flow in Financial Modeling

Image: CFI’s Advanced Amazon Modeling Course.

As you can see in the above example, there is a lot of detail required to model the operating activities section, and many of those line items require their own supporting schedules in the financial model.

Video Explanation of the Statement of Cash Flows

Below is a short video tutorial explaining how the three sections of a cash flow statement work, including operating activities, investment activities, and financing activities.

Additional Resources

Thank you for reading this CFI guide to Operating Cash Flow. To continue learning and progressing in your career, these additional CFI resources will be helpful:

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