Financial modelling terms explained

Operating Cash Flow

Discover the ins and outs of operating cash flow and financial modeling terms in this comprehensive article.

Understanding the financial health of a business is crucial for investors, stakeholders, and the management team. One of the key indicators of a company's financial health is its operating cash flow (OCF). This term, often used in financial modelling, provides an insight into the actual cash generated by a company's core business operations. In this comprehensive guide, we will delve into the concept of operating cash flow, its calculation, and its significance in financial modelling.

Understanding Operating Cash Flow

The operating cash flow is a measure of the cash generated by a company's regular business operations. It is an important metric as it indicates whether a company is able to generate sufficient positive cash flow to maintain and grow its operations. If a company is consistently generating more cash than it is using, it has the potential to increase dividends, buy back shares, pay down debt, or invest in new projects without needing to borrow or raise equity.

Operating cash flow is different from net income as it does not include non-cash items such as depreciation and amortization, which are usually included in the net income. It also excludes any cash flows from investing and financing activities. Therefore, it provides a clearer picture of how much cash a business is generating from its core operations.

Calculating Operating Cash Flow

The calculation of operating cash flow can be done using two methods: the direct method and the indirect method. Both methods will yield the same result, but they approach the calculation from different angles.

The Direct Method

The direct method for calculating operating cash flow involves adding up all the cash payments and receipts, including cash received from customers, cash paid to suppliers, cash paid to employees, and cash paid for operating expenses. The formula for the direct method is:

Cash Received from Customers - Cash Paid to Suppliers and Employees - Cash Paid for Operating Expenses = Operating Cash Flow

The Indirect Method

The indirect method, on the other hand, starts with net income and then adds back non-cash expenses (like depreciation and amortization) and changes in working capital. The formula for the indirect method is:

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

Importance of Operating Cash Flow in Financial Modelling

Operating cash flow plays a crucial role in financial modelling. It is a key input in many financial models, including the Discounted Cash Flow (DCF) model, the Leveraged Buyout (LBO) model, and the Merger and Acquisition (M&A) model.

In the DCF model, the operating cash flow is used to calculate the Free Cash Flow to the Firm (FCFF), which is then discounted to the present value to determine the value of the company. In the LBO model, the operating cash flow is used to determine how much debt the company can service, and in the M&A model, it is used to evaluate the target company's performance.

Moreover, the operating cash flow is also used to calculate several important financial ratios, such as the Cash Flow Margin, the Operating Cash Flow Ratio, and the Cash Flow to Debt Ratio, all of which provide valuable insights into a company's financial health.


Operating cash flow is a vital financial metric that provides a clear picture of a company's ability to generate cash from its core business operations. It is a more reliable measure than net income as it excludes non-cash items and cash flows from investing and financing activities. Understanding how to calculate and interpret operating cash flow is essential for anyone involved in financial analysis or financial modelling.

Whether you are an investor, a business owner, or a financial analyst, having a thorough understanding of operating cash flow can help you make informed decisions about a company's financial health and future prospects.

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