Operating Cash Flow and What it Means for Your Business

While cash flow is important, calculating your operating cash flow can provide you with a much clearer picture of how profitable your business really is.

Updated March 18, 2020

Cash flow and operating cash flow are two of the accounting terms that all business owners should be familiar with. Cash flow includes total revenues that flow into your business while operating cash flow is obtained from direct business operations; excluding outside revenue sources in its calculation.

The operating cash flow formula is an important calculation, particularly for investors and lenders who may be looking to invest in your business. This calculation should also play a role in calculating financial projections for your business.

Overview: What is operating cash flow?

To understand operating cash flow, you first must understand your cash flow statement. While cash flow includes all types of revenue including investments, cash flow from operating activities or operating cash flow, focuses solely on operating activities, providing you with your cash flow from core business operations exclusively.

Some of the things that affect operating cash flow include your company’s accounts receivable turnover. Revenue also impacts your operating cash flow since you’ll recall that using the revenue recognition principle, revenue is recognized at the time of service, but if invoices are not paid promptly, this can directly affect your cash flow. Other items that can affect cash flow include interest expense paid on any notes payable.

For instance, if your business relies heavily on outside investments or other cash sources, you will likely have a solid cash flow number. Unfortunately, that number doesn’t tell you whether your business is truly profitable, or simply relying on outside investments to pay bills.

Removing that revenue from the equation will provide you with a much more accurate cash flow number, as well as a more realistic view of how profitable your business truly is.

While the operating cash flow calculation is typically used by larger businesses (all publicly held companies must report this in their financial reports), if your business has a lot of outside revenue flowing in, it can be helpful to calculate your operating cash flow.

How to calculate operating cash flow

Calculating operating cash flow starts with net income or revenues. There are two calculation methods that can be used to calculate operating cash flow: the direct method, which is a simple calculation, and the indirect method, which is more complex, but provides more insight into a company’s performance and profitability.

When performing your operating cash flow calculation, be sure not to mix up cash flow with free cash flow, which also subtracts large investments such as property, plant, or equipment purchases.

Direct method calculation:

Total Revenue - Operating Expenses = Operating Cash Flow

Here is an operating cash flow statement using the direct method:

Jones Bookstore
Operating Cash Flow - Direct Method
For Year ending December 31, 2020
Debit Credit
Operating Activities
Cash from Sales
Sales Revenue $     45,000
Less Paid Transactions
Cost of Goods Sold $       (5,000)
Accounts Payable $         1,250
Inventory $         9,000
Utilities $        (1,000)
Wages $      (18,000)
Interest Expense $        (2,500) $     (16,250)
Net Cash from Operating Activities $       28,750

The direct method starts with revenue and simply subtracts operating expenses. This is the quick calculation, but doesn’t provide the detail that the indirect method does.

Indirect method calculation:

The indirect method of calculating operating cash flow adds back depreciation expense and removes gain from investments, since we want to calculate cash flow only from operations. The formula for calculating operating cash flow using the indirect method is as follows:

Net Income +/- Changes in Assets & Liabilities (including increase in accounts receivable, inventory, and accounts payable) + Non-Cash Expenses = Operating Cash Flow

Here is an operating cash flow statement using the indirect method:

Jones Bookstore
Operating Cash Flow - Indirect Method
For Year ending December 31, 2020
Debit Credit
Operating Activities
Cash from Sales
Net Income $     67,000
Deduct Non-Cash Transactions
Depreciation $       4,000
Gain from Investments $   (22,000)
Accounts Payable $       1,250
Utilities $      (1,000)
Wages $   (18,000)
Interest Expense $     (2,500) $     (36,750)
Net Cash from Operating Activities $      28,750

Non-cash expenses include depreciation, stock-based compensation that has been issued, and accruals, while change in working capital indicates a change in assets and liabilities on your company balance sheet. For instance, an increase in accounts receivable would indicate a reduction in cash, since accounts receivable is the balance of what customers currently owe and have not yet paid.

What does operating cash flow tell you about your business?

Operating cash flow is a valuable marker for showing true business profitability. For instance, let’s use Jones Bookstore as an example.

According to the reports above, Jones Bookstore currently has Net Cash from Operating Activities in the amount of $28,750. But Jeff Jones, the owner of the bookstore, has also invested in a small coffee shop next door to his bookstore, which pays him profits on his investment quarterly.

If Jeff were to include the $22,000 he received in profits from the coffee shop, it would raise his net cash flow considerably, but it would also provide a less accurate view of the profitability of his business since the $22,000 received from that investment has nothing to do with whether Jeff is making a profit selling books.

Below are a few questions that operating cash flow can answer:

What is my true business profit?

While outside investments and other sources of revenue can be helpful for small business owners, they also distort what your true business profit is. Keep in mind that if the net cash or net operating cash flow of your business is regularly higher than its net income, that indicates that your business is profitable. However, if net income is consistently higher than operating cash flow, questions may arise as to why net income is not being properly converted to cash.

Am I in a good position for future growth?

Good cash flow, particularly good operating cash flow is important for business growth. Whether growth is part of your strategic plan, or you’re just exploring the possibility of growth, knowing your operating cash flow number is vital. It’s also important to potential investors and bank officers if you’re looking to obtain funding.

How healthy is my business?

Making a profit is the goal of any business owner, and calculating your operating cash flow allows you to see just how much of a profit you’re making from selling your product or service. Knowing your cash flow will also help determine whether your business is in a position to pay staff and keep current on bills, now and in the future.

FAQ

Frequently Asked Questions

I’m a small business owner. Do I need to calculate operating cash flow?

It wouldn’t hurt. Even small business owners can benefit from knowing the cost of operations, and whether your business is really profitable.

How does net income differ from operating cash flow?

Net income reflects the profit that a company has earned over a specific period, while operating cash flow reflects the true profit of the business by excluding capital expenditures, investment income, and dividends paid.

Do I need to use accounting software to calculate operating cash flow?

No, but it does make it a lot easier, since accounting software automates much of the entire bookkeeping/accounting process, while also reducing errors.

Operating cash flow is a good marker for all businesses

Whether you’re preparing a business budget or providing information to investors, knowing your operating cash flow ratio can be a helpful indicator of true business profitability.

While you may have outside investments that can help keep your business afloat during rough times, your operating cash flow provides you with the information you need to determine true profitability from the business alone.

If you’re looking for accounting software to help you calculate your operating cash flow, be sure to check out The Blueprint’s accounting software reviews.

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