Sufficient cash flow is essential to running a healthy business. What some entrepreneurs don’t realize, however, is that the healthiest businesses generate a fair share of their cash flows from normal business operations, as opposed to other sources like investment income or equity funding.
This type of cash flow is know as cash flow from operating activities, or OCF, and reveals the money that your business generates from ongoing events, such as the sale of products and services.
While long-term capital and investment costs are not factored into cash flow from operations, the figure does reflect earnings before interest and taxes. Additionally, this form of cash flow reflects changes in short-term debts, accounts payable and accounts receivable. In this way, cash from operations is the cash version of net income. And with 28% of U.S. businesses citing cash flow as one of their biggest concerns, calculating this figure accurately is very important.
Importance of Tracking Cash Flow From Operations
Both business owners and shareholders have plenty of reasons to track cash flow from operations on a regular basis. Because OCF reveals the cash produced by core business activities, some say this metric offers the most realistic view of a company’s long-term fiscal health.
Along with helping a business tailor future product and service offerings, cash flow from operations can tell owners and investors how much money is available for financing options using short-term capital. In the long run, OCF can have a profound effect on a business’ opportunity to secure funding.
The fact is that a business can demonstrate positive net earnings but be unable to fulfill its debts. For this reason, many financial experts say that cash flow from operations is far more helpful than an income statement in assessing business profitability. On the other hand, if net income exceeds cash flow from operations by a large margin, investors may conclude that the business’ earnings quality is lacking.
Choosing the Best Cash Flow Metric for Your Business
While all the methods for calculating cash flow are valuable, not every metric is equally suited to all business types. Cash flow from operations, for example, is a solid metric for companies with machinery and other fixed assets, such as buildings, real estate, equipment and office furniture. Because companies don’t pay for depreciation costs using cash, their operating cash flow will be higher—and potentially more accurate—than their net income.
Additionally, cash flow from operating activities is a vital measure to track if your business is looking to secure investors in the coming months. Investors are typically eager to know the percentage of a company’s money that comes from regular business operations as opposed to investing and financing activities. After all, they want to know that cash is coming in regularly and not just as a result of one-time gains, stocks or bonds. Cash from operating activities shows shareholders and financiers that they are investing in a responsible business that has ongoing income and the capacity to pay its debts.
How to Track Cash Flow From Operating Activities
Fortunately, tracking net cash from operating activities is fairly simple. To start, find your EBIT, or earnings before interest and taxes. Next, account for depreciation, or the declining effect that wear and tear has on the value of a company’s assets. The equation then looks like:
EBIT + Depreciation – Taxes = OCF
Additionally, you can use the indirect method for calculating OCF. Start by finding your company’s net income. Next, add back in the values of non-cash expenses, such as depreciation and amortization. Finally, adjust for gains and losses on the sales of assets, as well as changes in non-cash current assets and variations in current assets and liabilities.
In general, companies with positive OCF boast more reliable net incomes and are better able to survive market changes and economic downturns.
Anyone who’s ever run a business knows that cash is of vital importance. Not only does cash enable businesses to satisfy their debts and pay dividends, but it also allows for the development of new products and services. As a result, businesses with negative cash flow from operating activities need to strategize quickly in order to cover their shortfalls. By staying on top of your cash flow from operations, you can avoid seasonal shortages and give your business the best shot at going the distance.
For more help on tracking cash flow, see our article on the six essentials of a cash flow statement.