What is operating cash flow?

9 minutes

How well do you understand your business finances? According to a survey from the U.S. Bank, 82% of businesses fail due to a poor understanding of their operating cash flow.

Staying on top of your working capital can ensure that you have the resources to maintain and grow your core business operations. This guide will help you learn more about how to measure your operating cash flow so you can better manage your company's finances.

What is considered operating cash flow (OCF)?

Operating cash flow (OCF) refers to the net cash that your business generates from your regular, day-to-day business operations. At its simplest, OCF represents your company's revenue after you deduct operating expenses. It can also be referred to as:

  • Cash flow provided by operations
  • Cash flow from operating activities
  • Free cash flow from operations

Your OCF reflects your company's ability to turn a profit. As a business owner, you'll want to aim for a higher OCF. This growth means that you're increasing your capital without the need for additional funding to cover your expenses. Otherwise, you may need additional funding to maintain your core business activities.

Operating cash flow vs. free cash flow

It's important to distinguish between OCF and free cash flow. While OCF reflects cash generated by your regular business activities, free cash flow accounts for capital expenditures. Capital expenditures (CAPEX) involve purchasing long-term assets such as property or equipment.

Operating cash flow vs. net income

Both OCF and net income provide a picture of your overall profitability. Net income represents your business income minus all of your operating expenses.

Technically, net income is a better metric of your profitability, as you can have strong cash flows yet still fail to turn a profit. But OCF is vital for knowing how much cash you have access to for covering your business operations.

Why is operating cash flow important?

Operating cash flow represents the ability of your business to sustain itself, financially speaking. For financial analysts, lenders, and potential investors, OCF is an essential measure of a company's financial health. OCF is a strong predictor of the company's ability to generate a profit or pay back a business loan.

Negative operating cash flow means that the business is not self-sustaining. Instead, the company depends on loans or other financing activities to cover its associated expenses. Negative operating cash flow is okay in the earliest phase of a business, but you must soon rectify it for the business to have enough money to stay afloat.

Operating cash flow formula

How do you determine your operating cash flow? Simply apply the cash flow formula. 

This formula is typically displayed on your cash flow statement. Every company's cash flow formula will be slightly different, but its simplest form will follow this basic structure:

Operating cash flow = (net income) + (all non-cash expenses) - (net increase in working capital)

Here's how these components work together in the operating cash flow formula:

1. Net income

Net income refers to the net profits from a business after taxes have been deducted. This figure appears at the bottom of a company's income statement and can be used to link the income statement and the cash flow statement.

The net income will have to be adjusted for changes in working capital reflected on the company's balance sheet, showing the importance of keeping track of your financial statements.

2. Non-cash expenses

Non-cash expenses include any accrual-based operating expenses that are not paid by cash during the period of time that you're evaluating. For instance, these expenses can include depreciation, stock-based compensation, deferred taxes, and other expenses.

3. Net working capital

Non-cash (or net) working capital refers to all of your current assets (except for cash) minus all of your current liabilities. Common examples of non-cash working capital items include:

  • Accounts receivable
  • Accounts payable
  • Prepaid expenses
  • Inventory
  • Long-term debt
  • Deferred revenue
  • Other operating income

This section is often where you'll see the most change to your operating cash flows during a given period, as your sales and debts will fluctuate over time.

How to calculate operating cash flow

Practically speaking, there are two methods for calculating your operating cash flow: the direct method and the indirect method. Each method will use a slight variation of the operating cash flow formula described above.

1. Direct method

As the name may imply, the direct method is the simplest. This method gives a business owner a quick snapshot of the total cash available during the accounting period. To calculate your OCF using the direct method, simply use the following formula:

Operating cash flow = (total revenue) - (operating expenses)

Again, this is a simple method, but a business owner can use this method to gain a quick snapshot of their company's operations. You can use the direct method to easily record things like:

  • Employee salaries
  • Revenue from customers
  • Income from investing activities
  • Cash paid to vendors
  • Interest payments
  • Income taxes

The direct method can give you a handle on how your business operates.

2. Indirect method

Generally accepted accounting principles (GAAP) require that you use the indirect method when preparing the operating cash flow section of your cash flow statements. When you use the indirect method, the operating cash flow formula is as follows:

Operating cash flow = (net income) +/- (changes in current assets/liabilities) + (non-cash expenses)

This method provides a far more detailed financial analysis. For instance, depreciation is added to net income for a more accurate look at your financial stability, and the formula also takes non-cash expenses into consideration.

Calculating operating cash flow: An example

Meet Tyra. Tyra owns an eCommerce business that earns money selling athletic wear. She's considering expanding her business and possibly even opening a retail store in her community. To do this, she'll need to have enough working cash to proceed.

She'll use the indirect method of calculating her OCF. After gathering her financial documents, she assembles the data:

  • Net income: $350,000
  • Depreciation: $45,000
  • Accounts receivable adjustments: +$75,000
  • Inventory adjustments: -$35,000
  • Accounts payable adjustments: -$60,000

Recall the indirect operating cash flow formula:

Operating cash flow = (net income) +/- (changes in current assets/liabilities) + (non-cash expenses)

Tyra simply plugs her data into the equation. Notice that her depreciation will be part of her non-cash accounts, while her inventory, accounts receivable, and accounts payable will all be part of her assets and liabilities:

Operating cash flow = $350,000 + $45,000 - $75,000 + $35,000 - $60,000

Doing the math, Tyra discovers that she has $295,000 in operating cash flow. This total means that she can use this working capital to invest in her business.

How to improve your overall cash flow

With greater OCF, you'll be better equipped to cover your expenses and grow your business. But how can you improve your overall cash flow? Here are some strategies to improve your cash flow.

1. Encourage clients to pay faster

Start by focusing on your accounts receivable — the money your clients owe your business. The faster you receive payment, the sooner you'll have cash on hand. That's why it's important to encourage your clients to pay their invoices on time. There are several ways to do this, including:

  • Allowing clients to pay their bills online
  • Sending automated payment reminders
  • Assessing late fees for late payments
  • Offering discounts to those who pay within seven days of the invoice

For example, offering a small 5% to 10% discount for early payment may mean that you make less money overall, but it means you'll have greater cash inflows to work with during a designated period.

2. Negotiate your accounts payable

Depending on your business or industry, many of your operating expenses simply can't be cut. But you may be able to negotiate a better deadline.

If you can extend your payment deadline a bit further, you'll have more money to work with each month. For instance, if you can avoid paying all of your bills and suppliers in the same period, you'll have more cash on hand than if you pay all of your creditors at once.

3. Automate your core processes

Consider automating as many operating activities as you can. For instance, you can easily use software to manage your invoices, record payments, and communicate with your clients.

Automation may save you money compared to hiring a full-time employee. Even if you handle these administrative responsibilities yourself, the right software package can save you time and keep you focused on your core business activities.

4. Decrease your inventory

For some business owners, this may seem counter-intuitive. But why waste so much capital on maintaining unsold inventory? Not only does it take up space, but these physical assets can tie up resources that might be better spent elsewhere.

If you're worried about meeting consumer demand, start slow. The next time you order inventory, reduce your order by 5% to 10%. You may discover that you'll be better able to use those savings elsewhere in your business.

5. Cut unnecessary spending

Unnecessary expenses create cash outflows that can cut into your working capital. Take a hard look at your yearly budget. Are there any items that you can eliminate?

Maybe you don't need that extra office space and can use it to house inventory. Maybe you can switch to a more affordable internet service or phone plan. Taking steps to be more frugal in one area can give you more flexibility in others, especially when you free up some working cash that can be used to grow your business.

Software to streamline your business

You'd be surprised at how much cash you can save by automating some of your administrative processes. Invoice2go has been providing services to countless small business owners across the U.S., helping them create invoices, accept electronic payments, and review their financial health with our advanced reporting features.

You can see these features in action when you sign up for a free trial. After all, your business is your passion, and your passion is worth investing in.

Frequently asked questions

Unless you have a degree in corporate finance, many of these terms and equations will seem unfamiliar. That's okay. The more you use them, the more you'll adapt. Here are some common questions about calculating and managing your OCF:

Which financial statements do I need to calculate my operating cash flow?

To calculate the OCF of your small business, you'll need your income statement or your balance sheet. Both of these documents will be useful in showing profits and losses that you'll use when preparing your operating cash flow statement.

Remember, however, that an income statement represents the profits and losses that occur over a specified period of time, whereas balance sheets will show profits/losses at a specific point. Therefore, you may find that your income statement offers a fuller picture of your business over time. This analysis might be part of your yearly evaluation of your company.

My business has a strong operating cash flow. Does that mean my business is profitable?

Not necessarily! Remember: your OCF only shows you how much cash you physically have to work with. That figure by itself doesn't tell you how profitable your business is overall.

In other words, it's possible to have a strong working cash flow yet still have a negative net income. For example, you may be sitting on a pile of cash but have so many outstanding debts that your business model is simply not generating a profit. Looking at your OCF is important, but it will never be the sole metric of your company's financial health.

How does operating cash flow impact my taxes?

Fortunately, the IRS will never be interested in your company's cash flow statements. You'll only need to report your income to the IRS, and the reporting procedure will depend largely on how your business is structured.

However, the income taxes that you pay will be considered an operating expense, and you'll need to factor in your tax liability when calculating your OCF. Incidentally, this is why it's wise for small business owners to pay estimated quarterly payments, as this ensures that these expenses don't significantly deplete your working cash reserve after covering your tax debt.

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