by Sam Franklin | June 29, 2022 | 11 min read
Operating cash flow - what it tells you about your businessGet funded
Last updated: July 08, 2022
“Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.” – Peter Drucker.
If you’ve been following our cash flow series by now, it should be well and truly established that financial analysis, forecasting, and in-depth knowledge of your cash flow is imperative for the long-term success of your SME.
You’re also probably coming to realise that there are many different ways of measuring your cash flow - with each metric revealing different snippets of information about your business’s finances.
Operating cash flow is no different. It’s a vital metric that tells you how effective your normal business operations are at generating cash. So much so that it’s one of the key factors scrutinised by financial analysts when assessing a company’s viability for investment or lending.
Read on to learn what separates operating cash flow from other cash flow metrics, what ratios your business should be aiming for, and how to improve your operating cash flows.
Before we do that, let’s find out what operating cash flow is and how it’s calculated.
What is operating cash flow?
On a company’s cash flow statement (found on your company’s financial statement), there are three main components:
Cash flow from operating activities*, cash flow from investing activities, and cash flow from financing activities.
*Cash flow from operating activities (CFO) is also commonly referred to as operating cash flow (OCF), which is how we’ll be referring to it in this article.
As you can see, operating cash flow (OCF) doesn’t include any cash from investing or financing activities - these are reported separately. Therefore, OCF represents the net amount of cash generated solely from your core business operations over a specific period.
Examples of core operating activities include:
Cash receipts from providing services & goods sold
Research and development
Production of goods
Basically, any cash inflow or outflow relating to the direct operations of your business - the difference between these inflows and outflows provides the operating cash flow figure.
Table of Contents
- Advantages of analysing OCF
- How to calculate OCF
- The indirect method
- The direct method
- What is EBITDA, and what does it measure?
- EBITDA vs OCF
- Operating cash flow vs free cash flow (FCF)
- Operating cash flow ratio
- How to increase your company’s OCF
- The bottom line
Advantages of analysing OCF
As operating cash flow only focuses on core operations by excluding cash from financing and investments, it’s a very useful metric to check your company’s core performance.
OCF gives a clear indication of the cash generating abilities of your main operations - you can see whether your core product alone is making enough positive cash flow to pay your liabilities and grow your operations, or whether you may need external financing.
A good comparison that highlights the significance of this is when you compare OCF to a company’s net cash flow, which can be altered by non-cash items.
For instance, if your business relies heavily on outside investments or other cash sources, you’ll likely have a strong net cash flow. However, as you’re relying on outside investments to pay bills, it’s not identifying whether your business is truly profitable - operating cash flow calculation cuts out these non-cash transactions.
How to calculate OCF
There are two methods to calculate operating cash flow: the indirect method and the direct method.
Which method you use ultimately boils down to the volume of transactions you make, how quick you need your operating cash flow statement, and how you would like to use that statement.
We’ll take a look at the advantages and disadvantages of both after learning how to calculate them.
The indirect method
Operating cash flow = net income + changes in working capital (for the accounting period) + non-cash expenses
Net income = adjusted to a cash basis to show the actual cash received in the period - most companies report net income on an accrual basis (revenue or expenses recorded when the transaction happens rather than when payment is actually received or made).
To do this, take the net income figure and add or deduct the non-received cash.
Working capital = current assets - current liabilities.
Current assets = cash, accounts receivable, inventory.
Current liabilities = accounts payable.
The changes in working capital must be accounted for as they won’t be reflected in net income.
For example, an increase in accounts receivable indicates that revenue was earned and reported in net income on an accrual basis (although cash hasn’t been received). This increase in accounts receivable must be subtracted from net income to find the true cash impact of the transactions.
On the other hand, an increase in accounts payable indicates that expenses were incurred and booked on an accrual basis. This increase in accounts payable needs to be added back to net income to be accurately reflected in the operating cash flow calculation.
Non-cash expenses = expenses that didn’t involve an actual cash transaction (e.g. depreciation and amortisation) but were recorded in the income statement. You add these non-cash expenses back.
Indirect method pros
Easier and quicker to prepare as it uses data already collected in your profit and loss statement.
Useful for gaining a quick snapshot of your OCF.
Widely used, therefore easy to familiarise with.
Suited if you have high transaction volumes.
Indirect method cons
Less accurate as it is based on estimated adjustments.
Less transparent as it doesn’t break down sources of cash.
Doesn’t allow you to analyse your sources of cash.
The direct method
The direct method of operating cash flow formula ignores the non-cash transactions.
It uses cash-basis accounting to directly track the cash impact of all business transactions instead of the accrual accounting and adjustment method.
Operating cash flow = operating revenue - operating costs
Operating revenue = total revenue from core business activities (cash collected from customers for sales of goods and services, interest income, etc.)
Operating costs= costs of running core business (salaries paid out to employees, cash paid to vendors and suppliers, R&D, utility bills, income tax paid, interest paid to lenders, etc.)
Direct method pros
More accurate than the indirect method as no adjustmentsare needed to reflect accounts receivable.
Good for in-depth analysis as it provides a clear picture of cash inflows and outflows.
Can be used to identify opportunities where cash expensescan be decreased.
Effective to analyse the potential impacts of increased cash expenses for investment and plan accordingly for predicted negative cash flow.
Accepted by the generally accepted accounting principles (GAAP) and international accounting standards (IAS).
Direct method cons
More complex and time-consuming to prepare, especially if your business has a high volume of transactions.
What is EBITDA, and what does it measure?
EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortisation, is also a financial performance metric that’s used to establish a business’s operating profitability.
It measures your business’s operations by removing the major non-cash charges (depreciation & amortisation), financing aspects (interest), and taxes - therefore, focusing solely on profitability from core operating activities.
There are two ways of calculating EBITDA:
EBITDA = net income + taxes + interest expense + depreciation & amortisation
EBITDA = operating Income + depreciation & amortisation
EBITDA can give a quick estimate of the value of a company and is very useful for comparing your performance to competitors as it removes the effects of financing and capital expenditures. It’s also often used to measure a company’s ability to service debt.
EBITDA vs OCF
Both EBITDA and OCF look to determine how well a business generates cash from its core operating activities by excluding cash from investing or financing activities.
The fundamental differences between the two are:
The EBITDA calculation doesn’t consider the increases or decreases in working capital accounts which may change as a business grows.
Operating cash flow calculates interest paid and income tax due to being actual cash expenses.
EBITDA is not recognised by the Generally Accepted Accounting Practice (GAAP).
Operating cash flow vs free cash flow (FCF)
So, now we know how operating cash flow is calculated - what’s the difference between operating cash flow and free cash flow?
In short, they are both measuring different things.
Operating cash flow is only concerned with the amount of cash generated by your business’s core operating activities. In contrast, free cash flow looks at how effectively cash from those core operations is generated.
Let’s take a closer look at what this means - operating cash flow includes interest payments and doesn’t subtract capital purchases. However, FCF is calculated as your operating cash flow before interest payments and after subtracting capital purchases (e.g. buying, upgrading, and maintaining assets).
Therefore, FCF helps you determine how well your business is generating cash from operations and how much cash is impacted by capital expenditures - think of FCF as the cash left after financing projects to maintain or expand the asset base.
Gerrard of ABC Trading does an operating cash flow calculation that indicates his business has a healthy amount of capital generated from his core business activities. Happy days.
However, when Gerrard calculates his FCF, he realises that his cash outlays show his business has taken on a significant level of debt due to capital expenditure. His business isn’t in such a strong financial position, as suggested by his operating cash flow. Gerrard now has a headache.
The truth is that both free cash flow and operating cash flow are important metrics and, when used together, should give you a comprehensive understanding of your company’s financial health.
Operating cash flow ratio
Operating cash flow (OCF) ratio is what’s known as a liquidity ratio.
It measures your business’s ability to pay off its current liabilities with the cash flow generated from core operating activities - essentially telling you the number of times your company can pay off current debts with cash generated within the same period.
OCF ratio is considered to be a very useful gauge of a company’s short-term liquidity as it’s not easily manipulated.
OCF ratio = cash flow from operations / current liabilities
Where current liabilities = obligations due (e.g. short-term debt, accounts payable, and accrued liabilities).
How to interpret
In essence, interpreting your OCF ratio is fairly simple.
A number greater than one indicates that your company has generated more cash from core operations in the period than what’s needed to pay off its current liabilities. Obviously, the higher the number means more profit is being generated from your operations.
On the flip side, an OCF ratio of less than one indicates your company has not generated enough cash to cover its current liabilities - which may suggest your company needs more capital.
It’s important to note that a poor OCF ratio is open to interpretation. It may not necessarily mean poor financial health. For example, if your company had just invested in a project that reduced cash flows temporarily but is expected to generate significant revenue in the future, then a low OCF ratio would be expected.
How to increase your company’s OCF
Like all cash flow, the goal is to reduce cash outflows and increase cash inflows - exceeding cash requirements to generate a positive cash flow. There are several methods to achieve this:
Reduce outstanding receivables - adopt strategies to encourage rapid payment.
Don’t pay your creditors early - ensure that accounts payable are not being paid before the agreed payment date. Additionally, consider negotiating longer payment dates with your suppliers.
Avoid redundant inventory - better manage your inventory to increase turnover.
Increase your profit margins - negotiate better deals from your suppliers or source alternatives, seek leaner business practices, avoid offering too much of a discount, and experiment with raising prices.
For a more in-depth look, check out our article on common cash flow problems and solutions.
The bottom line
So there you have it, operating cash flow - an essential metric of the total cash generated from your core business operations.
Whether you choose the indirect or direct method to calculate operating cash flow depends on your business’s circumstances- both will give you a good estimation of your OCF.
Like all cash flows, a net positive cash flow is the goal. However, it’s also crucial to keep track of your OCF over time - if it’s not steadily trending upwards, then it’s likely that your business isn’t increasing profits.
Sam founded his first startup back in 2010 and has since been building startups in the Content Marketing, SEO, eCommerce and SaaS verticals. Sam is a generalist with deep knowledge of lead generation and scaling acquisition and sales.