Managing cash flow is one of the most important aspects of running your business. You can’t maintain or grow your operations or pay your financial obligations without cash.

Cash flow indicates the health of a business and whether it will be a good investment. Cash flow comes from various sources, including sales, services, investments, and financing.

In your personal life, cash flow means that you can pay your bills on time. In business, a healthy cash flow allows your business to stay afloat.  

Cash flow is a calculation of money coming in and going out of your business. You have a positive cash flow if you have more cash generated than going out. You have a negative cash flow if you have more debts and liabilities than revenue.

Free cash flow is money coming in minus capital expenditures. Free cash flow can include cash available for reinvestment back into the business, and cash flow used to leverage debt.

Operating cash flow is money coming in minus money spent running the business. Be sure to brush up on your finance know-how in order to successfully run your business!

Companies submit a Statement of Cash Flows with their other financial statements. This report shows where the cash is originating and where it is going. While this is critical if you have investors or loans, knowing where your money is going is an excellent idea for any business.

What is Operating Cash Flow (OCF)?

Operating cash flow is money earned from its regular business activities. Whether a company makes a product or sells a service, the objective is to generate revenue. This revenue needs to be able to largely sustain the business.  

The operating cash flow formula is calculated by taking this revenue and subtracting a host of items. What’s left over is the cash you can use to pay your bills, including rent and salaries, stock up on inventory, develop new products, and so on.

There are two ways of calculating cash flows—the cash method and the accrual method—the difference boils down to when and how cash is reported.

The cash method recognizes revenue when cash is received and records expenses when cash is paid out. The accrual method recognizes revenue as it is earned and records your expenses as they are incurred.

The method recognized by The Financial Accounting Standards Board (FASB) is the accrual method, and this is what is reported on a Cash Flow Statement.

The Cash Flow Statement is a combination of cash flow from three activities of the business:

1. Operating Activities are money earned and spent running the business. This includes revenue, salaries, benefits, electricity, phones, etc.
2. Investing Activities are money used to purchase assets such as plant, property, and equipment, and any income generated from those assets
3. Financing Activities are money spent on loans or earned from the issuance of stocks

While investing and financing activities can contribute to operating activities, they are often one-time or periodic revenues. Operating cash flow is steadier and more predictable.  

Importance of Operating Cash Flow

Operating cash flow is one of the key indicators of a business’s health. Will the business be able to pay its employees, purchase inventory, invest in new capital, and, in general, keep its doors open for the foreseeable future? A solid operating cash flow signals to investors that the business is healthy. 

This particular type of cash flow helps fund capital investments, pays for increases in workforce, and allows you to fund other activities that keep the business operating in the black. Knowing your operating cash flow also alerts you to problems down the road.

If your operating cash flow is low, you can make plans to generate more income through sales or financing.

Investors look to operating cash flow calculation to determine whether your business is thriving. A steady or increasing cash flow indicates to investors that the company is efficient, profitable, and well-managed. 

A healthy operating cash flow also shows the liquidity of a business, which is crucial in raising funds through external sources.

Operating cash flow also helps to drive a number of investment metrics:

• Net Present Value – the value of a business at the current time
• Internal Rate of Return – a way of calculating an investment return while excluding external factors such as financial risk
• Cash Flow Yield and Cash Flow per Share – how much cash a business generates compared to its share price
• Cash Conversion Ratio – how quickly a business can pay its inventory based on when it receives payments from customers
• Funding Gap – how much a company needs to stay in a favorable cash flow situation
• Dividend Payments – these can be tied to cash flow

Helps Plan For Future Activities Such as Hiring New People

Completing a cash flow statement assists in financial planning and analysis of business activities. Let’s say you want to hire a new team member. Their salary will come out of operating cash flow. Cash flow numbers will illustrate if that money is in the budget and can be sustained. 

Before making a final decision, it’s essential to study the cash over time. Cash flow statements show trends and, if compared year over year, illustrate growth. Major decisions that will affect cash positions need to be considered carefully.

Cash flow statements can also be used to show investors a trend and could contribute to whether banks will loan the company money.

Types of Cash Flow from Operating Activities

Operating activities include cash inflows and cash outflows. Changes in values contribute to the operating cash flow calculations.

Inflows include:

1. Inventory
2. Tax assets
3. Accounts receivable
4. Accrued revenue

Outflows include:

1. Accounts payable
2. Tax liabilities
3. Deferred revenue
4. Accrued expenses

Changes in inflows and outflows can both impact operating cash flow. For example, for cash flow calculations, an increase in inventory or revenue will be backed out of net income, and an increase in outflows is added back into net income.

To generate cash flow, a company could do several things:

• Increase revenue by encouraging repeat customers, adding new customers, generating referrals, pursuing marketing leads, adding new products or categories, or raising your prices.
• Adjust your operating margin by obtaining better deals with suppliers, automating processes, managing returns, looking at your marketing budget, managing payroll, cutting overhead, or finding a new shipping partner.
• Examine capital efficiency via higher rates of return on assets, looking at proprietary technology, managing inventory, and increasing buying efficiency.

There are plenty of ways you can improve your profits. Sometimes, you just need to get creative!

Calculating Cash Flow

There are two ways to calculate operating cash flow: direct and indirect. While they both provide a picture of a business’s cash flow, each method has some advantages and disadvantages. 

Indirect Method

The indirect method is easier to prepare because the source of the numbers is the balance sheet and income statement. 

Follow these steps:

1. The net profit or loss comes from the income statement
2. Add back in all non-cash expenses
3. Depreciation and amortization—which is the process of writing off long-term assets such as equipment or buildings
4. This also goes on the cash flow statement with some calculations if you sell assets. Take the original price of the item, subtract the amount of depreciation, and then subtract the item’s sale price. This profit or loss on the sale is a non-cash expense.
5. Adjust for working capital. This is current assets (inventory and receivables) minus current liabilities (payables). This information comes from the balance sheet and compares the current and previous years.

Direct Method

The direct method is the recommended method of reporting operating cash flow due to its clearer picture of the inflows and outflows.

The direct method of reporting involves using a cash-basis accounting method: 

1. Start with the cash received from customers and any income received from interest and dividends.
2. Subtract cash paid to suppliers, cash paid to employees (in the form of salary, benefits, and bonuses), interest paid on investments, and taxes paid.

Limitations of Operating Cash Flow

There are some limitations to relying on the cash flow statement:

1. Net profit is not presented. Non-cash items are ignored, and the statement does not help determine if a company is profitable.
2. It cannot be looked at independently to determine how funds flow. You also cannot determine income by looking at the cash flow statement.
3. Comparing the cash flow statement between companies is not a good indicator of which is performing better. It fails to consider the number of capital investments or the company’s efficiency.
4. While the cash flow statement is an indicator of liquidity, it’s not an accurate projection of a company’s liquidity. The cash flow statement represents a particular moment that can fluctuate daily or weekly.

How Do You Calculate Operating Cash Flow?

In its simplest form, operating cash flow is calculated by taking your net income, adding your non-cash expenses, and subtracting the increase in your working capital. 

Non-cash expenses include deferred income taxes, unrealized loss and gain, writing down assets, stock-based compensation, depreciation, and amortization.

Use either the direct or indirect method of calculating cash flow. Your balance sheet and income statement will be your sources of information.

The Cash Flow Statement

A cash flow statement explains the difference between cash on hand at the beginning of a period of time as opposed to the end of that period.

The cash flow statement covers three different types of cash flow—cash from operating activities, investing activities, and financing activities.

Operating Cash Flow VS Free Cash Flow

There are many different ways to look at cash flow, and we will discuss one more. Like operating cash flow, free cash flow is money from normal business operations or activities.

The difference is that free cash flow is the cash on hand minus capital expenditures, which are funds used to buy, maintain and upgrade assets such as property, plant, and equipment. 

Investors can see how well a company generates cash from operations and how much a company is vested in capital expenditures. It also shows the cash available to investors before debt repayments, dividends, or repurchasing of shares of stock.

In fact, the higher the free cash flow number, the more dividends are available for the investors.  Free cash flow shows investors how efficient a company is at generating cash.

Free cash flow and operating cash flow are good places to compare competing companies.

Operating Cash Flow VS Net Income

Net income and operating cash flow are two ways to examine a company’s finances. They are both valuable in discerning whether a company is in a good financial state and is a prudent investment. They both use some of the same information, but provide different results.

Net income is the bottom-line number—the result of revenues minus taxes, expenses, and cost of goods sold. Investors look at net income to determine whether revenues are higher than expenses—earnings per share use net income in their calculations.

Net income by itself is not always accurate, as expenses can be hidden or revenue can be inflated. How a company’s bottom-line looks often depends upon when numbers are reported.

Operating cash flow is a better report for determining a company’s success. High operating cash flow indicates that a company’s net income will rise. It’s a better gauge of a company’s health.  

The Bottom Line

Operating cash flow is a valuable financial calculation. It’s not only a reporting requirement, along with the balance sheet and income statement, but it is also a vital number that shows where you’ve been and are going. It illustrates places to pay attention to and areas where you are thriving.

Corporations use operating cash flow to attract investors and assure their shareholders. Small businesses can use it in much the same way by seeing cash inflows and outflows and examining areas of improvement. 

Even if you’ve hired an accountant, take the time to understand operating cash flow, which method is used to calculate the numbers and how it represents your business. 

We’ve got you covered, whether it’s financial statements, cost-cutting ideas, questions about taxes, or other topics related to running your business. Want to learn more? Check out these other financial articles and guides to better your business!