What does operating mean?
In business, finance, and accounting, the term ‘operating’ describes the ongoing activities which a business performs during its normal day-to-day business operations.
The article intends to explain the following terms in which the term ‘operating’ appears:
- Operating activities
- Operating cash flow (OCF)
- Operating cash flow margin
- Operating cash flow ratio
- Operating costs
- Operating income
- Operating lease
- Operating loss
- Operating margin
- Operating ratio
- Operating revenue
What are operating activities?
Operating activities are the core business activities performed by a company to generate revenue.
Core business activities comprise activities such:
- Activities that generate revenue (income)
The two main types of revenue-generating activities are the providing of services and the manufacturing and distributing of products and goods. The distributing of goods may include reselling of materials and merchandise received from other suppliers.
- Sales-generating activities
Marketing and promoting products and services are essential for a business in order to build product awareness and generate sales.
There are numerous ways and methods to advertise a business, such as networking opportunities at business forums, advertisements in newspapers (local and national) and/or on other media platforms, and social media.
- Supporting activities
Supporting activities, also sometimes called back-office activities, encompass, amongst others, accounting, administrative, and security activities.
While these activities are indispensable to the day-to-day activities of a business, they do not generate income. Instead, they reduce the profits of a business.
Operating activities provide the majority of a business’s cash flow and are reported on the income statement of a business, computing the net income, as well as on the statement of cash flows.
What is operating cash flow (OCF)?
Operating cash flow (OCF), also referred to as cash flow from operations, refers to the amount of cash generated by a business from its core activities during a given financial period, such as a quarter or year.
OCF is an indication of whether a business is able to generate sufficient cash positive cash flow to maintain and expand its core business activities.
OCF is the first section outlined in a business’s statement of cash flows, followed by investing activities and financing activities, respectively.
Accountants mostly use the indirect method to report the operating cash flow of a business.
According to the indirect method, cash flow from operations is calculated as follows:
The starting point is the net income, also called the bottom line, derived from the bottom of the income statement, sometimes referred to as the profit and loss statement.
Adjustments for non-cash items, such as:
- Depreciation, an accounting method in which the values of assets like vehicles and equipment are reduced over a certain period of time. In other words, the expense amount of depreciation is added back because it is not a cash expense.
- Other expenses or income could include items such as unrealised profits or losses or accrued items
Changes in working capital (operating assets and liabilities)
Simply put, growth in operating assets or decreases in liabilities from one financial period to another represents use of cash, reducing cash flows from operations. For example:
- Inventory – An increase in inventory at the end of a financial period means a reduction in cash.
- Accounts receivable (AR) – An increase in the balance of AR causes a reduction in the cash balance, meaning a portion of the revenues recorded have not yet been paid by debtors. Vice versa, when accounts receivable decrease, it implies that several customers have paid their accounts, increasing the amount of cash received.
- Accounts payable (AP)
An increase in AP is added to net income. Contrarily, when accounts payable decrease from financial period to financial period, the difference is subtracted from net income.
In short, to calculate operating cash flow is to start with net income from the income statement, add non-cash items, and then incorporates any changes in working capital by adding or deducting.
What is the operating cash flow margin?
Operating cash flow margin is a profitability ratio in accounting that measures a business’s cash from operating activities as a percentage of sales revenue over a given financial period.
Put differently, it is an indication of how efficiently a business converts it sales to cash.
The formula to calculate the operating cash flow margin of a business is:
Operating cash flow margin = Operating cash flow (OCF)/Sales x 100
Example
Let us say company Bountiful reported a net income of R700 000 for the past financial year. Its depreciation on vehicles and equipment was R30 000. The working capital increased from R170 000 to R190 000, a change in working capital of R20 000. The company generated sales of R850 000.
The operating cash flow margin of company Bountiful will be calculated as follows:
Operating cash flow margin = (R700 000 + R30 000 + R20 000)/R850 000
= R750 000/R850 000
= 0.88 x 100
= 88%
The operating cash flow margin of 88% implies that 12% of the company’s sales revenue is used to cover various expenses. Put differently, the company turned 88% of its revenue from sales into cash, which is an exceptionally positive figure.
What is the operating cash flow ratio?
The operating cash flow ratio is a liquidity ratio in accounting, determining how efficiently a business can cover its current liabilities with cash generated from its core business operations.
Operating cash flow (OCF) is preferred over net income (earnings) because earnings comprise accruals and can be manipulated by the management of a company.
The formula for the operating cash flow ratio is:
Operating cash flow ratio = Operating cash flow/Current liabilities
Where:
- Operating cash flow is calculated by starting with net income from the income statement, add non-cash items, and then incorporates any changes in working capital by adding or deducting.
- Current liabilities are debt obligations due within one year or less.
This ratio indicates how much a business earns from its operating activities, per one South African rand (ZAR) of its current liabilities.
What are operating costs?
Operating costs refer to a business’s day-to-day costs, comprising:
- Cost of goods sold (COGS), also known as cost of sales, are the costs incurred when manufacturing products and/or providing services.
COGS are the costs deducted from sales revenue to calculate gross profit, also called gross revenue.
- Operating expenses (OPEX), also known as SG&A (selling, general, and administrative) expenses.
There are numerous operating expenses that are associated with the ongoing administration and maintenance of a business. Expenses such as rent, marketing, bank charges, repair and maintenance, travel, office supplies, and salaries.
Operating expenses do not include non-operating expenses like interest, legal expenses, and losses involved in foreign exchange transactions.
All the figures to calculate a company’s operating costs are reported on the income statement.
What is operating income?
Operating income is the amount of revenue remaining after deducting the direct and indirect operating expenses from sales revenue.
Operating income is also referred to as:
- operating profit,
- operating earnings,
- earnings before interest & taxes (EBIT), or
- income from operations.
Three formulas are available to calculate the operating income of a business:
- Operating income = Total revenue – Direct operating expenses – Indirect operating expenses
Or
- Operating income = Net income + Interest expenses + Taxes
Or
- Operating income = Gross profit – Operating expenses – Depreciation – Amortisation
What is an operating lease?
Simply put, an operating lease is an agreement (contract) where the lessee is allowed to use assets, such as vehicles, heavy equipment, or aircraft. However, an operating lease does not transfer ownership to the lessee.
Contrarily, a capital lease enables the lessee to take ownership of the asset.
Operating and capital leases are recorded differently in a lessee’s accounting system. For example:
- Operating lease
Lease payments are considered operating expenses and are recorded on the income statement. An operating lease is not reported on the balance sheet of a business.
- Capital lease
The leased asset and the lease obligation are reported on the balance sheet of the lessee.
The lessee is allowed to claim depreciation on the asset as well as interest expenses which are reported on the income statement.
According to Corporate Finance Institute, a lease must satisfy any one of the following four conditions to be considered a capital lease:
- ‘A transfer of ownership of the asset at the end of the term.
- An option to purchase the asset at a discounted price at the end of the term.
- The term of the lease is greater than or equal to 75% of the useful life of the asset.
- The present value of the lease payments is greater than or equal to 90% of the asset’s fair market value.’
If none of the conditions above are met, then the lease must be dealt with as an operating lease.
What is an operating loss?
A business suffers an operating loss when its operating expenses exceed its gross profit. Express differently, an operating loss is the loss recorded on a company’s income statement before non-operating expenses are taken into consideration.
An operating loss could be an indication that the core operations of a business are not profitable and that changes are deemed necessary.
Reducing an operating loss can either be done by increasing revenues or by decreasing expenses. Typically, the immediate solution implemented by management is to reduce expenses. For example, the layoff of employees, reduce marketing expenses or discontinue the manufacturing of non-profitable products.
An operating loss is not necessarily a bad thing. A business may experience an operating loss because it is re-investing in itself for a period of time in order to extend and strengthen its operational capacity.
What is an operating margin?
An operating margin is a profitability ratio in accounting that measures how efficiently a business generates revenue (sales) through is core business operations.
The essence of an operating margin can be described in different ways. For instance, an operating margin:
- indicates the amount of revenue (sales) that can be used to cover non-operating expenses like interest on loans, legal expenses, and asset write-downs,
- measures revenue after operating and non-operating expenses of a business have been covered, and
- calculates how much profit a business generates on one South African rand (ZAR) of sales after covering the variable production costs, such as raw material and wages.
The formula to calculate the operating margin is:
Operating margin = Operating income/Revenue x 100
Where:
- Operating income is also referred to as operating earnings.
- Revenue is also called sales.
A higher operating margin is considered a better indication of overall profitability than a lower margin.
Operating margin is also referred to as return on sales.
What is the operating ratio?
The operating ratio is a measure used in accounting to determine how efficiently the management of a business manages the day-to-day operations of a business.
The ratio compares the operating expenses, also referred to as OPEX, of a company to net sales.
The lower the operating ratio, the more effectively a business is generating revenue in relation to its operating expenses.
Express differently, a low operating ratio indicates that operating expenses represent a small percentage of net sales.
The calculation for the operating ratio is as follows:
- To express the ratio as a decimal:
Operating ratio = (Cost of goods sold + Operating expenses)/Net sales
- To express the ratio as a percentage:
Operating ratio = (Cost of goods sold + Operating expenses)/Net sales x 100
What is operating revenue?
Operating revenue refers to the revenue that a business generates from its core business activities.
For instance, a business that operates drones derives its revenue from services provided to clients, such as mining and security companies.
Operating revenue excludes non-operating revenue, such as dividend income, gains from forex transactions, or any other revenue that occurs from unusual or one-off transactions.
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