It is pertinent to know and understand the techniques behind the success of your business or firm. Knowledge, they say, is power, so knowing your net profit and where you stand in business is highly recommended. Companies and businesses fold up, not because they lack the opportunity, skills, or manpower, but just because they don’t prioritize operating cash flow as essential and indispensable in their business pursuit. Cash flows are important as they give you a glimpse of where your business is heading in the near future. We shall be going on a cruise of what operating cash flow is, operating cash flow activities, and how to calculate it.
Cash Flow
In financial reporting and accounting, cash flow refers to the amount of money that comes in and goes out of a business. Businesses earn money and spend it on expenses. Simply put, cash flow is used in finance to denote the amount of money (cash) created or spent over a specific period of time. The entire amount of money moving in and out of the organization is accounted for by cash flow, which is among the most significant aspects of corporate operations.
Grasping Operating Cash Flow
Operating cash flow is the amount of money brought in by a company’s routine business activity. Operating cash flow, in essence, indicates whether a company is earning enough consistent revenue to stay in business and grow.
In a nutshell, it shows the amount of cash flow generated by the company’s operations without taking into consideration extra revenue sources such as interest or investments. This is a significant factor because it enables creditors and investors to analyze how successful a company’s operations are and whether the company is making enough money from its core activities to stay afloat and grow.
Again, it is the amount of money a company makes from its sales, excluding the costs of long-term capital investments and securities investments.
That is to say, if the company is unable to generate sufficient consistent revenue, it may need to seek outside funding to expand.
The section of the cash flow statement that displays how much money a company earns through day-to-day activities is called operating cash flow. It’s obtained by subtracting revenue from operational expenses.
Furthermore, the operating cash flow can be calculated using one of the two methods/formulas. The first approach, also known as the direct method, involves subtracting operating expenses from total proceeds.
Operating Cash Flow and Its Applications
To apply the cash flow from operating activities. One of the two ways shown below is adopted.
#1. Direct Method
This method is highly recommended by the Financial Accounting Standards Board (FASB). It is more detailed than the indirect method. This method, however, has a verification check and the indirect method is used to verify the direct method’s accuracy. For this reason, most businesses/firms prefer the indirect method and this is a great limitation of the direct method.
This shouldn’t discourage you, as we all know the saying that “Everything that has an advantage, has a disadvantage.”
Meanwhile, as its name implies, it considers the origin of the cash flows and records it on the statement sheets/report.
Example
Below is a typical example of using the direct method to generate a cash flow statement
Bellmall Mircosoft Inc.
Cash flow statement, for the year 2023
On the 30th of November
OPERATING ACTIVITIES CASH FLOWS
| Cash obtained from sales $80,000 |
| Cash spent on income taxes $2,500 |
| Cash spent on salaries $20,000 |
| Cash spent on commodities $25,000 |
| Cash spent on interest $1000 |
| TOTAL CASH FLOW INFLOW BY OPERATING ACTIVITIES $31,500 |
INVESTING ACTIVITIES CASH FLOWS
| Cash spent on assets and property $150,000 |
| TOTAL CASH INFLOW BY INVESTING ACTIVITIES $150,000 |
FINANCING ACTIVITIES CASH FLOWS
| Income from credit line $20,000 |
| Payments made on long-lived debt – |
| Income from long-lived debt $120,000 |
| TOTAL CASH INFLOW BY FINANCING ACTIVITIES $140,000 |
| NET CASH INCREASE $41,500 |
| BEGINNING CASH FLOW SITUATION – |
| CLOSING CASH FLOW SITUATION FOR THE YEAR 2023 $41,500 |
Thus, from the above sample, we can see that all the activities are well-detailed and itemized for clarity.
#2. Indirect Method
This is the change in capital or net income after deductions on the balance sheet to determine the precise amount of money earned from operating activities. This method helps uncover what a company spends and why. In essence, this technique informs managers, employees, and investors about what they’re getting into and the financial health of the company.
Now, to calculate the cash flows using this method, there are three basic categories to take note of
- Cash flows accruing from operating activities
- Cash flows accruing from Investing activities, and
- cash flows accruing from financing activities.
This is the most popular or frequently employed method, especially among small businesses or firms. Its limitation/disadvantage is that it doesn’t give a clear detailed glimpse of the inflow and outflow of cash in a business firm. With this in mind, the following are steps to calculating OCF.
To calculate Operating cash flow using this method
- Firstly, the net income minus the non-cash payments, Remember, Depreciation is an example of a non-cash payment.
- Secondly, add the cash value
- Finally, implement/report the variations that occurred because of investment and other factors to get the cash flow of a company.
Strategies for Generating Operating Cash Flow
In operating cash flow, the necessary things to consider are the operating cash flow activities, the cash flow investing activities, and the financial cash flow. Now, take them one after the order.
- The operating cash flow activities: Just like the name, this portrays the amount of money received from sales of goods and services minus the money spent on administrative purposes. Eg. cash spent on rent, salaries, utilities, bills, and necessities.
- The cash flow investing activities: This entails the amount of cash that flows into and from fixed assets such as structures, machines, trucks, furniture, computer, and other property acquired by a company.
- The financial cash flow: The cash invested or that flowed in through credited debts, the business owner, or by investors is recorded here.
At this point, it is pertinent that we itemized the things to bear in mind when generating a cash flow statement:
- Sales and receipts
- Loans
- Payments
- Net income
- Depreciation
- Net cash used in piloting financial ventures
- Gains and loss
- Cash produced from operations
- Cash produced from investing
- Finally, the cash flow statement of a company shows the cash generated through its financial activities and other sources.
Income vs. Operating Cash Flow
Income also known as net profit or revenue is the proceeds generated by a company minus taxes, depreciation, and various expenses made for the effective function of the company.
The net income is also included in the statement/report sheet, alongside all expenses.
There are also non-cash expenditures such as depreciation, share-hinged reimbursement, etc.
On the contrary, operating cash flow is the total sum of cash or its equivalents that comes in and goes out of a business. i.e., the inflows and outflows of cash that accrue on a daily basis as a result of operational activities in a company are known as operating cash flow.
Again, OCF is the total amount of cash created from the sale of goods and services, investors, cash spent on assets, properties, investments, taxes, insurance, dividends, etc., are altogether operating cash flows whereas, Income is the gains made by a company fewer expenses.
Operating Cash Flow Activities
The amount of money a firm gets through its continuous, regular business operations, such as manufacturing and selling things or providing a service to consumers, is referred to as cash flow from operational activities (CFO). In the financial statement, operating activities are a categorization of cash flows. Cash flows are mostly related to revenues and expenses. Items classified within this section are a company’s core income activity.
Cash flow, which is one of the most important components of business operations, accounts for the overall amount of money going in and out of the firm.
Importance of Operating Cash Flow Activities
The following are some of the key importance of OCF activities.
- Generally, it helps businesses and their administrators see how and where their money comes from and where it is going.
- It also aids in making crucial cost-effective financial decisions.
- It assists businesses to create and keep sufficient cash for operational effectiveness as well as other requirements.
- Finally, it helps the administrators of a business foresee and plan for the betterment of the company.
Operating cash flow activities are of great essence and therefore, cannot be overlooked for the proper well-being of a business or firm.
How to Calculate Operating Cash Flow
Key formulas for calculating cash flows
- Free Cash Flow= Net income + Depreciation – Expenses – change in working capital
- Operating Cash Flow = working Income + Depreciation – charge duty + change in operating capital.
- Cash Flow Estimate= Initial cash + Cash Inflows Forecast – Cash Outflows Forecast = Closing Cash Flow Situation
The above formulas are vital in calculating OCF
Now, above all, let’s do some practicing using each key formula:
#1. To Calculate Operating Free Cash Flow
As a manager, you’ll need help determining the company’s suitability for employment.
Net income/capital = $50,000
Depreciation =$500
Expenses = $1,500
Change in operating capital = -$5,000
{$50,000} + {$500} — {$1,500} – {$5,000} = $47,000
According to the information above, the company’s management has $47,000 available for reinvestment.
#2. To Calculate Operating Cash Flow
Using the same example above, let’s assume the yearly accounting record is as follows:
Working Income = $100,000
Depreciation = $1000
Charge Duty = $ 25,000
Change in operating capital: – $ 15,000
{100,000} + {$1000} – {$25,000} + {-$15,000} = $91,000
Therefore;
Initial Cash = 50,000
Cash inflow forecast for the next 120 days = $ 50,000
Cash outflows forecast for the next 120 days = $8,000
{$50,000} + {$50,000} – {$8,000} = $ 92,000
What Practical Cash Flow Statement Issues?
- Differences in classification between the operational and cash flow statements
- Non-monetary activities
- Issues with internal coherence between the general purpose financial statements
What is a Cash Flow Statement?
A cash flow statement records and analyzes an organization’s incoming and outgoing cash flows.
“The purpose of the statement of cash flows is to present a more comprehensive picture of what happened to a business’s cash over an accounting period,” according to an online Financial Accounting course.
How to Prepare a Cash Flow Statement?
- Find the starting point of balance
- Get the necessary operating cash flow to run the business
- Determine the Cash Flow from Investing Activities
- Determine how much money is coming in from financing.
In Essence
As the owner of a business or as a manager, you need to know if employing more people will be feasible for the company or not. You get to also know the financial health of your company. Additionally, operating cash flow indicates whether a company is earning enough consistent revenue to stay in business and grow.
Operating Cash Flow FAQs
What is used in calculating operating cash flow using the indirect method?
- Cash flows accruing from operating activities
- Cash flows accruing from Investing activities, and
- cash flows accruing from financing activities.
What is the benefit of operating cash flow activities?
Generally, It helps businesses and their administrators see how and where their money comes from and where it is going.
It also aids in making crucial cost-effective financial decisions.
What is an example of calculating operating free cash flow?
Net income/capital = $50,000
Depreciation =$500
Expenses = $1,500
Change in operating capital = -$5,000
{$50,000} + {$500} — {$1,500} – {$5,000} = $47,000
What is Operating Cash Flow Activities?
The amount of money a firm gets in through its continuous, regular business operations, such as manufacturing and selling things or providing a service to consumers, is referred to as cash flow from operational activities.
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