Along with a balance sheet and income statement, calculating operating cash flow is one of the most important activities you can do for your business.

Cash flow looks at the inflows and outflows of cash in your business. With anything in accounting, there are a few ways to look at cash.

In this article, we’ll focus on cash used in operating your business and why you should care about this valuable snapshot.

What is Operating Cash Flow?

Cash generated during the course of running a business is called operating cash flow. It tracks money coming into and going out of your business. It is reported on the Statement of Cash Flows along with cash from investing and financing activities.

While many companies exist with investments and loans, knowing how to manage cash flow will create a sustainable business practice and lead you closer to profitability.

In its simplest form, operating cash flow is net income plus non-cash expenses minus increases in working capital. 

In its extended form, it still starts with net income. Then you add depreciation, stock-based compensation, deferred tax, other non-cash items, increases in accounts payable, increases in accrued expenses, and increases in deferred revenue.

Finally, subtract increases in accounts receivable and increases in inventory. Your calculation will vary depending on what items you have to account for. 

The operating cash flow formula can use the indirect or direct method, depending on whether you use a cash-based or accrual-based method.

Why is Operating Cash Flow Important?

Operating cash flow provides valuable information on whether you can sustain your business in the near future. It illustrates whether you can cover your expenses and partially whether you will turn a profit. 

Lenders look at a cash flow statement to see if they can repay debts. Investors use it to determine if they want a stake in your business. Cash flow numbers can also pinpoint areas of concern.

If you are turning a profit but still struggle to pay supplies on time, your cash flow statement will give you a good idea of why.

Investors look at operating cash flow to determine how a company is growing and whether it will make them money in the future. A positive cash flow instills confidence in investors.

It’s important to note that a positive cash flow does not necessarily indicate that a business is profitable, and turning a profit does not guarantee the business has cash on hand.

Operating Cash Flow Ratio Components

Calculate the operating cash flow ratio by taking operating cash flow divided by current liabilities. Operating cash flow comes from the Statement of Cash Flows, and current liabilities come from the balance sheet. (Current liabilities are due in the current year; other liabilities are longer-term.)

The results of the operating cash ratio will either be a number more than one or less than one. A number of more than one means that operating cash flow exceeds current liabilities. A number less than one means that your operating cash flow is less than your liabilities.

This doesn’t mean the business is in trouble, but it is not as healthy as it could be. It means that investing or financing is needed to keep going. It could also mean that your business has invested heavily in its future. 

The higher the number, the more cash flow you have compared to bills. While this would generally be a fantastic thing, compare it to other months. Is this ratio a matter of timing or a consistent number? Is the business investing in its future?

Operating cash flow numbers will indicate liquidity. Liquidity is how easily or efficiently you can convert an asset or security into cash without affecting its market price. Cash is the most liquid asset.

Other assets will take some effort to turn into cash, but it can be done in time. For example, a piece of equipment or security can be sold depending on market conditions. 

There are two different types of liquidity – market and accounting. Market liquidity allows assets to be bought and sold in the market at stable prices. The time it takes to sell something on the market varies.

While real estate is liquid, the market dictates whether you will be able to sell it and collect cash in a quick enough amount of time to cover your needs. Accounting liquidity measures how easily a company can pay off debts as they become due.

This is done by comparing liquid assets to current liabilities and determining a ratio. Investors will compare this ratio to other companies to see how you compare.

The Operating Cash Flow Ratio VS the Current Ratio

While the operating cash flow ratio looks at the ability of a company to pay its current liabilities with operating cash flow, the current ratio looks at the ability of the company to pay those same liabilities with current assets.

Current assets are cash, cash equivalents, accounts receivable, market securities, pre-paid expenses, inventory, and other liquid assets that can be converted to cash within a year. Equipment that has a life of several years or property you intend to keep is not included in current assets.

The current asset ratio is calculated from the balance sheet and takes the current assets divided by current liabilities. You can think of the current asset ratio as a measure of short-term liquidity.

The difference between operating cash flow and current ratios is how quickly a company can convert its assets to cash through liquidation. 

How to Calculate Operating Cash Flow

Operating cash flow can be calculated in a few different ways:

1. Cash received from sales minus cash paid for operating expenses (direct method)
2. Net income plus depreciation minus change in working capital (the indirect method)

Indirect Method

The indirect method is easier to prepare because the source of the numbers is the balance sheet and income statement. The formula commonly used is net income plus depreciation and amortization minus the change in working capital.

Follow these steps:

1. The net profit or loss comes from the income statement
2. Add back in all non-cash expenses. Take an item’s original price, subtract the depreciation amount, and then subtract the item’s sale price. This profit or loss on the sale is a non-cash expense.
3. Add Depreciation and amortization expenses—which is the process of writing off long-term assets such as equipment or buildings
4. 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.

Only cash transactions that occurred during the reporting period are included. The calculation is cash sales or revenue received minus cash paid for operating expenses.

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.

Operating Cash Flow VS Net Income

Net income results from revenues minus taxes, expenses, and the cost of goods sold. Investors look at net income to determine whether revenues are higher than expenses.

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 depend 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.

How Are They Similar?

Both operating cash flow and net income provide valuable information regarding how well a business is performing and how they use its cash in the course of operations. They are both used by investors and business owners to determine cash inflows and outflows. 

How Are They Different?

The first difference is in how each number is calculated. Net income is earned revenues minus expenses, including taxes and the cost of goods sold.

Operating cash flow considers inflows and outflows from operating activities. It also uses cash from revenues but excludes cash from non-operating sources such as interest and investments. 

Net income focuses on the bigger picture of a company’s finances. It provides a better insight into the profitability of a company.

As net income uses the accrual method of accounting, it makes assumptions regarding some income and expenses due to the timing of when these are reported.

For example, if a company is invoiced this year and doesn’t pay until next year, revenues might look inflated as there is no cash on hand.

Operating cash flow is a narrower picture of a company as it ignores money from investments or financing. It’s not until one looks at the rest of the Statement of Cash Flows that one sees these numbers. Operating cash flow is used to gauge a company’s liquidity as its focus is on cash. 

When you compare the two numbers, one may exceed the other due to the timing of payments or depreciation of assets. This may seem unclear until you look at the numbers driving each calculation.

The Difference Between Cash Flow and Profit

Cash flow and profit might seem the same, but they are exclusive. A business can turn a profit as long as they have the cash to operate, but it cannot operate without an influx of cash. Improving cash flow can affect profitability.

Cash flow is inflows and outflows during a certain period of time. Cash flow can come from operations, investments, or financing. `A company can either have a positive or negative cash flow depending on whether you have more money moving in or out of the company.

Profit is the difference between the money earned and the expenses incurred. Profit can include money that hasn’t been collected or money that hasn’t been paid.

The company is said to be operating at a loss if expenses are greater than proceeds. If proceeds are greater than expenses, you have turned a profit. Profits are either paid to shareholders or invested back into the company. 

The main difference between the two lies in whether you receive cash for your sales. If a customer does not pay you what they owe, you have earned income but haven’t received cash. Thus, you may show a profit but have a negative cash flow. 

Types of Profit

There are several ways of calculating profit:

1. Gross profit is revenue minus the cost of goods sold, which are the costs incurred with producing goods. The costs must be directly related to the production of goods. These include labor and materials but do not include the rent and salaries of individuals. Gross profit measures efficiencies in your process. It will go up when your cost of goods sold decreases.
2. Operating profit is the net profit generated from normal business operations. Sometimes called EBIT, or earnings before interest and tax payments, it excludes these items and positive cash flows from outside the core business. For example, if you make a product but also rent out a space in your warehouse to someone else, that secondary piece of income would not be included in the operating profit related to your product.
3. Net profit is gross profit minus expenses, but unlike operating profit, those expenses include taxes and interest payments. Net profit is a suitable parameter for the health of your business.

The Income Statement

Your income statement looks at what you’ve earned vs. what you’ve incurred.

In other words, its calculations are based on what you expect to receive or pay out rather than what actually occurred. This is prepared using the accrual method. If you use the cash method to prepare an income statement, you will get an idea of cash flow. 

The income statement is the initial number to determine cash flow. Remember to look at the balance sheet, income statement, and statement of cash flows to get a comprehensive picture of your business finances.

The Bottom Line On Operating Cash Flow

It’s critical to understand operating cash flow. It is a gauge of your company’s liquidity and an excellent indicator of the health of your company. If you can cover your bills with your revenue, you won’t have to rely on outside sources for as much financing.

But if you do decide to seek out investors, your company will look very attractive. Either way, it’s an excellent snapshot of where your money is coming from and going.

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