Operating Cash Flow: What is it and How to Calculate it

Available to promise (ATP) is the projected amount of inventory a business has in Inventory, ready to sell and not allocated for existing customer orders. Using ATP, companies can keep the minimum amount of a specific item, which maximises warehouse space and reduces customers’ chances of seeing items as “backordered.”

This article will explore examples of ATP in action and how you can use it to maximise profits.

What is operating cash flow?

Operating cash flow (OCF) is the amount of cash generated by a business’s regular activities—the sales of its products and services—within a given period. OCF serves as a measure of whether a company can generate sufficient positive cash flow to maintain and grow its operations.

In simpler terms, OCF is calculated by subtracting operational costs (i.e., rent, utilities, and other production-related expenses) from gross revenue.

Why is OCF important to small businesses?

Operating cash flow is important because it offers a sound indicator of profitability, helping you measure whether your company is making more money selling a product than it spends producing it. Overall, OCF is a sound marker of your company’s performance.

Cash flow is one of the most important calculations for small businesses because it represents a true indicator of a company’s financial health. It determines if a company can pay both fixed expenses (i.e., rent, utilities, payroll) and variable or unplanned expenses (i.e., equipment, software, facility repairs, legal fees). It also provides lenders and creditors with immediate insight into a business's current financial health.

Calculating OCF offers full transparency into a company’s true profitability and is one of the purest measures of cash sources and uses. This means that you can monitor changes in cash (using the cash flow statement) and the impact on the income statement and the balance sheet.

So what does this all mean for you, the small business owner?

With a consistently clear picture of your cash flow situation, you’re better positioned to make sound, informed business decisions, such as:

• Can we afford to expand the business?
• Do we have enough to cover fixed expenses?
• Can we invest in new equipment without risking a cash shortfall?
• Do we need to cut expenses to survive a lean sales period?

How to calculate operating cash flow

There are two commonly used methods for calculating operating cash flow: direct and indirect. Both are acceptable under generally accepted accounting principles (GAAP).

The direct method of cash flow calculation is more straightforward—reporting all major cash receipts and cash payments. The indirect method is a bit more complex. It backs into cash flow by adjusting net profit (or net income) with changes applied from noncash transactions. At the end of the business day, you can use either method to perform an analysis.

To help you determine which method is the best fit for your business, we break each down for you here.

Direct method

Operating cash flow formula: Total revenue – operating expenses = OCF

To use the direct method, use total revenue and total operating expenses posted on the income statement.

This formula is simple to compute, and it’s often ideal for smaller businesses, partnerships, and sole proprietors. The smaller the business, the less diverse your income sources and expenses usually are. This makes the direct method a better way of showing your business’ true cash flow amounts.

Example: The following offers a real-world example of an OCF statement using the direct method:

The direct method is often favourable to smaller businesses that seek a simplified calculation. It’s important to note that while simple is appealing, the direct method does not provide information at a granular level.

Indirect method

Operating cash flow formula:

Net income +/- changes in assets and liabilities + noncash expenses = OCF

The indirect method uses the financial statement of cash flows formula to compute cash flows from operations. The statement of cash flows reports increases and decreases in cash on a cash basis and divides the activity into three categories:

• Cash flow from financing activities: This category includes raising money by issuing stock or debt, paying stockholders dividends, and repaying debt.
• Cash flow from investing activities: Cash transactions that involve buying and selling company assets.
• Cash flow from operating activities: All of the cash activity that is not included in the first two categories. This includes working capital activities, such as purchasing stock, making payroll, and collecting customer payments.

You can calculate cash flow from operating activities using the indirect method. Here is the indirect formula in detail:

• Net income
• Add: Decreases in current assets
• Add: Increases in current liabilities
• Add: Noncash expenses
• Subtract: Increases in current assets
• Subtract: Decreases in current liabilities

Current assets include cash and assets that are expected to be converted into cash within 12 months. Inventory, for example, is expected to be sold within a year. On the other hand, current liabilities are expected to be paid within 12 months. Your accounts payable balances are a current liability.

Non-cash expenses include depreciation and amortisation expenses. Depreciation expenses are posted to record the decline in value of physical assets, including machinery or equipment. You post amortisation expenses to record the decline in value of intangible assets, such as a patent.

The formula is complex, so let’s use a basic example to explain how the calculation works. Assume a company has $50,000 in net income, and other accounting activity that impacts the formula:

• $50,000 net income
• Add: $5,000 decrease in inventory (current asset)
• Add: $2,000 increase in accounts payable (current liability)
• Add: $10,000 in depreciation expenses (noncash expense)
• Subtract: $12,000 increase in accounts receivable (current asset)
• Subtract: $4,000 decrease in long-term debt due within a year (current liability)

OCF equals $51,000.

Limitations of operating cash flow

Although it’s exceptionally important, OCF isn’t without its limitations. Consider the following:

Industry comparisons aren’t possible

Because OCF doesn’t measure a company’s efficiency, it’s impossible to make industry comparisons. For example, a company that has less capital investment will have less cash flow compared to one with more capital investment resulting in higher cash flows.

It doesn’t properly assess liquidity position

The cash flow statement does not assess a business’s liquidity or solvency position because it only presents a cash position on a particular date. OCF better serves as a forecasting tool to understand what amount of obligation can be met.

Operating cash flow vs. free cash flow: What’s the difference?

Both OCF and free cash flow (FCF) are valuable financial metrics. However, there are distinct differences.

• OCF is the net amount of cash generated from operating activities. Positive cash flow indicates that a company is better positioned to purchase inventory and pay expenses.
• FCF is the cash a business produces through its operations after subtracting outflows of cash for investments in fixed assets, such as property, plant, and equipment. In other words, FCF is the cash left over after a company has paid its operating expenses and invested in capital expenditures.

Operating cash flow vs. net income

Net income represents the profit a company has earned for a period. Cash flow from operating activities, on the other hand, is a measure of the cash going in and out due to a company’s day-to-day operations.

Net income is the starting point in calculating cash flow from operating activities. However, both are important in determining the financial health of a company.

What operating cash flow can tell you about your business

As stated earlier, OCF is one of the truest indicators of a company’s financial health. And when you understand your cash position (at all times), you’re better positioned to make key decisions that drive business growth.

The following are two key questions that OCF can help a business owner answer:

• How much cash does my company generate from daily operations? By removing all noncash sources of revenue, you get a truer indicator of OCF. Lumping other investments in with net cash will only distort your bottom line. Practically speaking, if net operating cash flow is regularly higher than its net income, you’re generating sufficient cash to operate the business.
• Is my business in a good position for growth? Good cash flow, particularly good operating cash flow, is important for business growth and overall business operations. Whether growth is part of your strategic plan or you’re simply 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.

Managing operating cash flow properly is one of the most important skills small business owners can master. Whatever your company size or the industry you serve, it’s vital that you stay on top of cash inflows and outflows. Doing so will let you access timely, accurate numbers that will drive key business decisions and ensure you’re turning a profit over the long term.