What Is Operating Cash Flow and Why Is It Important?

Financial

ACCOUNTING

Mir Amir Sohel

6/26/20236 min read

Hello Friends,

If you want to be a business owner, an investor, a financial analyst, or are simply interested in the financial world, then you are in the right place. In this blog, I will share my knowledge on Operating Cash Flow.

You have probably heard the saying, "cash is king." Cash is the lifeblood of any business, and without it, a business cannot survive for long. But it's important to know how to measure and determine how much cash a business generates from its core operations.

Operating cash flow (OCF) is a key financial metric that shows how much cash a business generates from its core operating activities, specifically how much cash is generated from selling products or services. It is crucial to correctly classify between Operating, Investing, and Financing Cash Flow.

Without generating positive cash flow, a business has to rely on financing cash inflow, which can lead to the company being unable to fund its growth initiatives (such as capital expenditure, investing in new projects, research and development, etc.) and paying down debt, potentially resulting in bankruptcy.

There are two methods to calculate operating cash flow: the Direct Method and the Indirect Method. However, most companies use the Indirect Method. In this blog post, I'll explain how to calculate operating cash flow using the Indirect Method. I will also discuss what should be included and excluded from this calculation, as well as how to adjust the numbers.

Indirect Method:

The Indirect Method starts with net income and adjusts it for any non-cash items and changes in working capital (working capital = current assets - current liabilities). You might be wondering what non-cash items are. Non-cash items are transactions that are included in the income statement but do not involve cash or involve cash in a future operating year. Examples include depreciation, court settlements that will be paid or received in the future, stock options, deferred tax, deferred revenue, deferred expense, etc.

Let's now dive back into the topic of changes in working capital. These changes refer to the current assets and current liabilities of a business. Working capital represents the day-to-day items needed to operate the business, such as inventory, trade payable (arising from buying inventory), trade receivable (amounts owed to the company by customers), and short-term loans.

Increases and decreases in working capital affect cash flow because they reflect the timing difference between when a business pays or receives cash and when it records revenues or expenses. An increase in current assets (such as trade receivables, inventory, deferred expenses, etc.) decreases cash, while a decrease in current assets increases cash. On the other hand, an increase or decrease in current liabilities (such as accounts payable, deferred revenue) increases or decreases cash, respectively.

The formula for calculating operating cash flow using the indirect method is:OCF = Net Income + /- Non-Cash Items - Changes in Working Capital

Now, let's calculate the Operating Cash Flow using Wal-Mart's 2022 Consolidated Cash Flow statement from the Annual Report.

(All figures are stated in million dollars.)

In this example:

- Consolidated net income in 2022, 2021, and 2020 is $13,940, $13,706, and $15,201, respectively.

- Now we adjust for non-cash and non-operating items:

1. Depreciation and Amortization are non-cash items:

In 2022: $10,658 million

In 2021: $11,152 million

In 2020: $10,987 million

2. Unrealized gain/loss is a non-cash item, and realized gain/loss from any investment is not considered an operating activity of Wal-Mart:

In 2022: Loss of $2,440 million

In 2021: Gain of $8,589 million

In 2020: Gain of $1,886 million

3. Gain/Loss on disposal of business operations:

In 2022: Loss of $433 million

In 2021: Loss of $8,401 million

In 2020: Loss of $15 million

4. Asda pension contribution:Wal-Mart divested from Asda in 2020, resulting in a $1,036 million pension obligation. This is more related to the disposal of business operations and is considered a non-recurring event.

5. Deferred income taxes:Deferred income tax arises from timing differences in income and expense recognition between tax laws and accounting laws. In 2020, Walmart had $320 million, in 2021 $1,911 million, and in 2022, a tax benefit of $755 million.

6. Loss/gain on extinguishment of debt:Loss/gain on extinguishment of debt is a non-cash, one-time event arising from the retirement of existing debt.

7. Receivables (current asset):Receivables arise from the sale of products or services for which the customer has not yet made payment. An increase in receivables decreases cash, and a decrease in receivables increases cash.

8. Inventory (current asset):Inventory consists of items, goods, semi-finished goods, merchandise, and materials held by a business for selling in the market to earn a profit. An increase in inventory decreases cash, and a decrease in inventory increases cash.

9. Accounts payable (current liabilities):Accounts payable mainly arise from buying inventory from suppliers. An increase in accounts payable means an increase in cash, and a decrease means a decrease in cash.

10. Accrued liabilities(current liabilities):Accrued liabilities are similar to accounts payable but arise from buying equipment, services from suppliers, legal fees, electricity bills, and other short-term liabilities from suppliers.

11. Accrued income taxes:Accrued income taxes represent either the amount the government owes to the company or the amount the company owes to the government. Accrued income tax is also a non-cash item for the current operating year.

Now, we can calculate the Operating Cash Flow (in million dollars):

Operating cash flow for 2022 = $13,940 + ($10,658 + $2,440 - $433 - $755 + $2,410 + $1,652) - $6,597 = $24,182

Operating cash flow for 2021 = $13,706 + ($11,152 - $8,589 + $8,401 + $1,911 + $1,521) + $10,008 = $36,074

Operating cash flow for 2020 = $15,201 + ($10,987 - $1,886 + $15 - $1,036 + $320 + $1,981) - $327 = $25,255

Use of Operating Cash Flow:

Operating cash flow serves several important purposes for investors:

1. Evaluating Financial Performance: Investors can assess a company's profitability and efficiency by analysing its operating cash flow. Positive and increasing operating cash flow over time indicates that the company generates enough cash to cover its expenses, invest in growth, and potentially distribute dividends.

2. Assessing Cash Generation: Operating cash flow helps investors understand the amount of cash a company generates from its primary business activities. It provides insight into a company's ability to generate sustainable cash flows, which is crucial for long-term viability.

3. Analysing Cash Flow Stability: By examining the consistency of a company's operating cash flow, investors can assess the stability of its business model. A consistent and predictable cash flow stream reduces the risk of financial distress and indicates a solid foundation to withstand economic downturns.

4. Comparing Competitors: Operating cash flow can be used to compare companies within the same industry. By assessing cash flow performance, investors can identify companies that are more efficient at generating cash from their operations, aiding in investment decision-making and identifying potential opportunities.

5. Assessing Capital Expenditure: Operating cash flow provides insights into a company's ability to fund its capital expenditure (Capex) requirements internally. Companies with strong operating cash flow can finance investments without relying heavily on external financing or increasing debt levels, indicating financial strength and reduced debt-related risks.

6. Valuation and Investment Decisions: Operating cash flow is used in various valuation models, such as discounted cash flow (DCF) analysis. By discounting projected future cash flows, investors can estimate the intrinsic value of a company's stock. Operating cash flow also plays a crucial role in determining a company's ability to pay dividends or repurchase its own shares, which are important considerations for income-focused or growth investors.

In conclusion, operating cash flow is a vital metric for investors as it helps assess a company's cash generation, profitability, liquidity, solvency, funding capacity, and long-term sustainability. By analysing operating cash flow alongside other financial metrics, investors can make more informed investment decisions and evaluate the financial strength of potential investments. Thank you for visiting my blog, and if you're interested in such topics, please subscribe to receive notifications.

Disclaimer: I am not a registered financial advisor with SEBI or any regulatory authority. The information provided on this website/blog is for educational and informational purposes only. It should not be considered as financial advice or a recommendation to make any investment decisions. Before making any investment, it is crucial to consult with a qualified financial advisor who can assess your specific financial situation and provide personalized guidance. Remember, investing involves risks, and past performance is not indicative of future results. The content on this website/blog should not be solely relied upon for making financial decisions. Always conduct thorough research and seek professional advice before investing. The responsibility for any investment decisions rests solely with the individual reader.

What Is Operating Cash Flow and Why Is It Important?