What is operating cash flow? | A complete overview

Your business made a tidy profit last year. Yet you're still struggling to pay wages and bills on time.

Wondering what you're doing wrong? The answer lies in cash flow, or rather, the lack of it. A recent report by Oracle reveals that cash flow monitoring is one of the top 14 financial challenges for businesses. Just like the human body needs food to survive, your business needs healthy and steady cash flow to grow and thrive. With adequate cash flow, you can pay bills on time, capitalize on market opportunities, and grow your business.

Whether you're a startup founder, a CFO, or an accounting executive, you need to keep a steady eye on the operating cash flow (OCF) to ensure long-term financial stability. In this article, we help you understand the importance of OCF, explain how to calculate it, and discuss how to interpret statements of cash flows to empower your business.

The basics of operating cash flow

Operating Cash Flow, or OCF, is a critical part of your financial statements. It shows how much money your business makes from your core operations. It gives a clear picture of the cash your business earns from everyday activities like sales, renewals, customer collections, and other receivables.

The OCF is truly the lifeblood of your business, as it's a reliable indicator of your company's potential to grow. A positive OCF indicates you can pay bills on time, invest in new opportunities, and handle unexpected expenses. In contrast, a negative cash flow is a warning signal that shows you might need to secure additional funding to keep the operations going.

Definition of operating cash flow

The OCF is a crucial financial metric that measures the cash a business generates from its core operations over a specific accounting period, say a quarter or a year. It provides insights into the company's ability to generate cash from its regular operating activities. In the simplest terms, it's the difference between revenue and operating expenses.

Key components of operating cash flow

The three major components of operating cash flow statements are:

• Net income: This is your company's total revenue minus all expenses, including taxes. It represents the amount of money a company has earned from its core business operations.
• Non-cash expenses: These are expenses that don't require cash payments. It usually includes amortization and depreciation expenses. You'll add non-cash expenses to net income when you calculate operating cash flow because they do not represent actual cash outflows.
• Changes in working capital: This includes changes in accounts receivable, accounts payable, and inventory levels. Changes in working capital can significantly impact a company's operating cash flow. An increase in accounts receivable, for example, can decrease operating cash flow, while a decrease in accounts payable can increase operating cash flow.

Why is operating cash flow analysis important?

OCF is a crucial part of your financial statements, along with your income statement and balance sheet. But it isn't just another number. It's the pulse of your business. Understanding the available cash ratio and its key components gives you critical insights into your business's financial health, operational efficiency, and liquidity. It helps you make informed decisions, overcome operational challenges, and navigate your business toward long-term financial stability.

OCF analysis offers the following benefits:

Financial health indicator

At the outset, your business might have an impressive net income. However, if your profitability isn't sustained with a healthy cash flow, it could lead to unsustainable practices and operational inefficiencies. Positive OCF also assures investors and creditors that you're a strong borrower and you have the cash to service current liabilities, debts, and other financing activities on time. A healthy OCF acts as the fuel for investments in new ventures, research & development, and even acquisitions.

Operational efficiency indicator

Tracking and analyzing OCF helps you get a clear idea of where your cash is going. You can evaluate if operational costs are eating into your profits and optimize spending without compromising on the quality of products and services. It also helps with inventory analysis. High inventory levels tie up your cash flow. With OCF analysis, you can identify slow-moving products, optimize inventory levels, and free up cash for other critical needs.

Liquidity assessment

Analyzing your cash flow helps you understand how quickly or slowly your customers pay you, and shows you if you need to adjust your credit policies. A consistent healthy cash flow shows fiscal stability, increasing investor confidence and attracting potential investors. It also helps you make informed decisions about pricing, discounts, marketing campaigns, and expansions.

How to calculate operating cash flow

There are two main methods to calculate the statement of cash flows:

1. The Direct Method: This method directly tracks the differences between cash flowing in and out in a given time period. Cash-in includes money collected from customers and dividends received, while cash-out comprises wages, salaries, supplier payments, taxes, and interest paid.
2. The Indirect Method: Most businesses opt for the indirect cash flow statement as it allows you to combine your income statement with the cash flow statement. This method helps you to calculate the differences between these statements, providing an overview of profitability and cash flow.

Operating cash flow formula

The formula to calculate OCF in the indirect method is:

Operating Cash Flow = Net Income + Non-Cash Expenses (+/-) Changes in Working Capital

Steps to calculate operating cash flow

Here's a step-by-step guide to help you calculate the OCF using the indirect method:

1. Calculate the net income: Calculating OCF starts with your income statement. Use it to note down the net income for the period you track cash flow. The net income is the total income generated from all sales and investments minus the total expenses.
2. Add non-cash expenses: These costs appear on your income statement but don't involve cash transactions. Some examples of non-cash expenses include depreciation, amortization, and deferred taxes. While these expenses aren't an actual cash outflow, they represent the decrease in the value of your current assets and impact your profitability.
3. Calculate the change in working capital: Calculate the difference in working capital from the beginning to the end of the period for which you're calculating OCF. Add or subtract the change in working capital to get the final OCF.

How to interpret operating cash flow results

Analyzing OCF goes beyond just looking at the final number. A deeper cash flow analysis gives you accurate insights into your business's financial health and operational efficiency. Here are a few tips to help you interpret your OCF results:

Understand the context

A positive OCF indicates that your core operations are sustainable and profitable. On the other hand, a negative OCF is a warning that you're spending more than your revenues.

Compare your OCF metrics to industry averages for your sector and business model. Similarly, compare your OCF trends with other companies with approximately the same years of experience as yours. For example, industries like manufacturing have longer cash conversion cycles, while SaaS businesses might show quicker cash turnover.

Analyze trends

Analyze OCF trends over time, not just single snapshots. Find out if OCF is consistently positive, trending up, or fluctuating. Examining OCF over multiple periods gives you a clearer picture of your financial trajectory. Consistently positive and growing OCF suggests robust operational health and potential for expansion. In contrast, declining or fluctuating OCF may warrant a closer look at your business strategies and operational processes.

Reconcile it with net income

Comparing OCF with net income provides a holistic picture of your finances. An OCF that is consistently higher than net income suggests your business effectively converts its profits into cash. This is a sign of good financial health. However, if net income is high but OCF is low or negative, it could indicate that you're not realizing profits in cash terms. This is possibly due to issues in receivables, inventory mismanagement, or other operational challenges.

Factors that affect operating cash flow

To diagnose and overcome financial issues, business owners need to understand the factors that affect net cash flow. Here are a few factors that can impact your OCF:

• Volume and value: Increased sales volumes directly boost cash inflows, while higher prices can improve margins and overall OCF. That said, if your pricing is too high, it could negatively impact sales, lowering OCF.
• Payment terms: Offering cash discounts can accelerate cash inflows, while longer credit terms may lead to temporary dips in OCF. In contrast, extending supplier payment terms can temporarily boost OCF, but you'll need to carefully balance this to avoid damaging supplier relationships. Finally, efficiently collecting customer payments keeps cash flowing in promptly.
• Seasonality: Businesses with fluctuating sales cycles may experience periodic ups and downs in OCF.
• Cost management: Efficient control of expenses like rent, salaries, and materials optimizes cash flow. On the other hand, excessive inventory ties up cash, while efficient inventory control releases cash for other uses.
• Fixed vs. variable costs: Higher fixed costs (rent, salaries) can create stability but limit flexibility during slow periods, impacting OCF. Optimal inventory levels reduce cash tied up in unsold goods without hindering production or sales. Significant investments in equipment or infrastructure may temporarily deplete OCF before generating future returns.
• External factors: Besides internal factors, external factors beyond your control can also impact your OCF. For example, strong market conditions generally lead to higher sales and improved OCF, while recessions can have the opposite effect. Similarly, any changes in tax regulations, interest rates, or trade policy changes can influence your business environment and OCF.

Stay informed and empower your business

Operating cash flow gives you accurate insights into your company's ability to make a profit from your core business operations, now and in the future. This insight can guide you in making strategic decisions and adjustments to ensure sustained growth and profitability.

As a business owner, consider switching to an automated solution to help you track and prepare accurate cash flow statements. Let AI-empowered bookkeeping software do the work so you can focus on what matters most — growing your business.