Running a startup is an exciting and rewarding endeavor. What makes it less exciting? Managing your operating cash flow.
Yet, it’s one of the most critical metrics you can track as a founder because of its effect on profitability and the day-to-day decisions that you have to make. Additionally, founders need to know how to manage it effectively, as mismanagement can increase burn rate and shorten your runway.
This article will explore the question "what is operating cash flow?" and explain why it is essential for your startup.
What Is Operating Cash Flow?
Operating cash flow is the cash a company generates through its daily operations. As mentioned, it’s an important metric for you to understand and manage, as it can impact the company's ability to survive and grow.
Investors often monitor a business’ operating cash flows to determine whether a business’s current operations are viable in the long term. Keeping a healthy, positive operating cash flow can increase your chances of successfully acquiring further funding if necessary.
Operating vs. Free Cash Flow
While operating cash flow measures cash generated from day-to-day operations, free cash flow measures the cash you have available before interest payments and after accounting for operating expenses and capital expenditures.
Capital expenditures, or CAPEX, are business funds spent on fixed assets. This could include purchasing company assets like buildings, industrial machinery, office equipment, vehicles, or land. Capital expenditures include funds to maintain or improve your business's current assets.
Free cash flow is the amount of cash a company has left over, which they use to repay creditors, buy back shares, and pay dividends. It measures your company’s ability to generate cash for shareholders, while operating cash flow measures your ability to generate cash for operations.
How To Find Operating Cash Flow
You can find this metric by examining your company's financial statements using the indirect or direct calculation method. Both ways are valuable tools to help you and your investors understand your company's financial health, but different types of companies often use them.
Indirect Cash Flow Method
With the indirect method, you’ll calculate operating cash flow by adjusting net income for non-cash items (such as depreciation and changes in working capital). Public companies typically use this method because they undergo regular audits.
Businesses that follow accrual accounting should use the indirect method. In this method, you record revenue and expenses at the time of the transaction or agreement instead of when the money is transferred. Accrual accounting gives a more accurate view of your startup's long-term finances. It’s also required for businesses with more than $25 million in revenue over three years.
Direct Cash Flow Method
When using the direct method, you’ll factor in all the cash generated and used in your business's operations during the current reporting period. This method is a good fit for small businesses with limited expenses but is less common.
The direct method reports all cash outflows and inflows in the current period, even if they include payments just received for services your business rendered in a past reporting period.
For example, if customers take their time paying for services, it may skew your startup's cash flow statements for the current and previous periods.
How To Interpret Operating Cash Flow
A favorable flow or a consistently increasing flow indicates that a company generates more cash from its operations than it is spending. Investors will see this as a positive indicator that the company is financially stable.
On the other hand, a negative cash inflow or a consistently decreasing flow indicates that a company is spending more cash on its operations than it generates. If a startup is far from reaching profitability, a negative flow often means it will need to raise further funding. Investors will see this as a red flag since it can indicate that the company is struggling financially.
Operating cash flow is also crucial for investors when evaluating different startups. Investors may use this number to compare your startup to competitors to decide where to allocate their money.
It's also important to compare operating cash flow to net income (found on your income statement) to measure profitability. A company can be profitable but still have negative incoming cash. In this case, the company may generate cash through non-operating activities, such as investments or financing.
Are There Other Types Of Cash Flows?
There are two other main types that we haven't discussed – investing and financing.
Investing measures cash generated and spent on long-term investments such as property or equipment.
If you invest in a new manufacturing plant or office building, this is a decrease in your investment cash flow. On the other hand, selling an investment would increase your investing cash flow.
Financing cash flow measures cash generated through financing activities such as issuing stocks or bonds.
If you decide to raise capital by issuing bonds, your financing cash will increase. Conversely, your financing cash will decrease if you need to repay a loan.
Why Is Operating Cash Flow Important For Startups?
Understanding operating cash flow is critical for your startup because it provides a clear picture of the day-to-day financial health of your business. This metric is essential for startups with limited funds trying to manage their burn rate and extend their runway.
If your startup struggles to cover its operating expenses, you might need more outside funding to stay afloat. However, investors may not see a negative or decreasing cash flow in a favorable light, making it difficult for your startup to secure additional funding.
Operating cash flow can be used to make strategic business decisions. By monitoring operating cash flow, you can identify areas where the business needs to improve its financial performance. This process can include cutting costs, increasing revenue, or seeking additional funding.
Monitoring Operating Cash Flow To Make Startup Decisions
Now that you know how operating cash flow works and supports your financial operations, make sure you have a system to monitor and keep your finances on track. By leveraging accounting software, you can easily monitor operating cash flow and make data-driven decisions to improve their chances of success.
Additionally, AI and machine learning software can deliver cash flow statements and other key financial metrics in real-time, so you always know exactly what's happening with their finances. This allows you to make data-driven decisions to improve your financial performance and increase your chance of success.
Learn more about how you can leverage accounting software to make better business decisions here.
