Around 82% of small business failures are linked to poor cash flow management, making it one of the most critical indicators of whether a business will survive or struggle. Yet many founders and finance teams focus heavily on profit, often overlooking how cash actually moves through the business on a day-to-day basis.
Cash flow issues may arise in profitable businesses if customers fail to pay on time, if the business has high initial operating costs, and if the company faces working capital shortages. As a result, such problems may stop businesses from correctly evaluating their finance positions and planning for long-term growth.
In this article, you’ll learn what Operating Cash Flow (OCF) is, why it matters more than profit alone, and how to calculate it using both the indirect and direct methods.
What is Operating Cash Flow?
The net cash that your company generates from its normal, daily activities is known as operating cash flow, or OCF. OCF measures actual cash derived from the company’s main business activities; it does not include cash generated from investing or financing activities. It may also be known as:
- Cash flow from core operations
- Cash flow from operating activities
OCF shows how well your business is able to generate cash through its operations. You should strive for a higher OCF as a business owner. This growth indicates that you are generating capital without requiring additional funds to cover your operating expenses. If not, you might require more funds to support your core business operations.
Why Operating Cash Flow Matters
Operating cash flow is a measure of your company’s financial viability. OCF is a crucial indicator of a company’s financial health for lenders, investors, and financial analysts. It is a reliable indicator of a company’s ability to generate cash for profits or to repay a business loan.
The company is not self-sustaining if its operating cash flow is negative. Rather, the business relies on loans or other forms of funding to cover its operating costs. In the early stages of a company, negative operating cash flow is acceptable, but it must be corrected quickly if the company is to have enough cash on hand to survive.
Operating Cash Flow Formula
You’ll probably use a variation of this formula to determine your operating cash flow, or the cash your company makes from routine operations:
OCF = net income + non-cash expenses ± changes in working capital ± non-operating gains and losses
There are two ways to use this formula: the direct method, which just considers the money coming into and leaving your bank account, or the indirect method, which modifies your net income to reflect actual cash activity.
Indirect method
The indirect technique extracts particular types of inflows and outflows from your accounting records, such as working capital, non-cash expenses, and one-time gains or losses, until you are only looking at cash. It is known as the indirect approach for this reason. By employing accrual formulas to generate the numbers, you are indirectly arriving at cash flow.
Since the majority of accounting systems operate using accrual accounting, this approach becomes easier to implement and is also in line with GAAP and IFRS reporting standards.
Direct method
The direct method determines operating cash flow by adding up all the cash inflows and deducting the cash outflows from operating activities, e.g., payments to suppliers, employees, interest, and taxes.
Although it gives insight into cash movement, tracking cash at this detailed level is often not supported by accounting systems; therefore, it is more challenging to prepare. Still, a few companies employ it for their internal forecasting and liquidity planning.
How do you calculate operating cash flow (OCF)?
Starting from your net income is the first step when calculating cash flow from operations. Then you make adjustments for items that affect your cash but not your profit.
The indirect technique is used by the majority of firms since it draws directly from financial statements that must already be prepared, such as a balance sheet and an income statement. This makes the method more efficient in practice; however, it does require some calculations to make sure you are excluding non-cash inflows and outflows so as to get an accurate picture of what your operating activities generate only.
Begin with net income
You will start with net income if you are using the indirect method. The aim is to make changes for non-cash items and other factors from here so that you can get the cash flow from the main operations only.
Include non-cash expenses
Any non-cash items, including depreciation and amortization, are then added back. These reduce your net income on paper, although you are supposed to include them since they do not actually cost you money. This will help convert your accrual-based profit into a cash-based amount that reflects better operational results.
Account for changes in working capital
Changes in working capital, particularly changes in current assets and current liabilities related to your daily operations, must now be taken into account. Although they don’t usually appear on the income statement, these adjustments affect how much cash you have available to spend. Cash is consumed by increases in assets like inventory or receivables and released by increases in liabilities like payables.
Remove non-operating gains and include losses
Any one-time earnings or losses unrelated to core activities are eliminated in your final adjustment. These are typically the results of investing activity, such as selling real estate or equipment. These are necessary for an accurate net income for the entire company, but they have no bearing on the OCF calculation because they are unrelated to the cash generated from operating the business.
Consider other operating adjustments
You might need to think about making changes beyond the fundamentals, depending on the size or complexity of your company. Do you postpone paying taxes? Do you provide remuneration based on stock? What about foreign exchange gains and losses? Although they won’t always be applicable, make sure to add or deduct them if they appear on your balance sheet.
Confirm using the cash flow statement
Regardless of timing, accounting regulations, or one-time gains and losses, you can now add up all the adjustments to get a clear picture of how much money your company gained from selling products or rendering services.
After the computation is finished, think about comparing the outcome to the company’s cash flow statement. The “official” OFC reported to lenders, authorities, or investors should be included in this report. “Cash flows from operating activities” is what you should look for. You might have miscalculated your changes or omitted important line items if the numbers don’t add up.
FAQs on Operating Cash Flow
Here are answers to some of the most common questions about OCF to help you apply it confidently in your day-to-day financial decisions.
Why is operating cash flow more important than net income?
Net income can include non-cash items and one-time gains that don’t reflect actual money in your account, while OCF shows only the cash your operations truly generate.
What does negative operating cash flow mean?
It means your business is spending more cash on operations than it’s bringing in, which often signals a need for external financing to keep things running.
How does operating cash flow affect business decisions?
If your OCF is strong, you’ll be able to confidently allocate funds towards expansion, recruiting, or even debt repayment, without having to depend on loans. Conversely, a poor or negative OCF indicates that there is a need to reduce spending drastically, even before any big decisions are taken.
What factors can impact operating cash flow?
Customer payment dates, supplier agreements, stock levels, and changes in operating expenses can, at times, significantly alter your operating cash flow (OCF). In fact, poor cash flow can even arise in a profit-making month if the collection of invoices is delayed.
Can a profitable company have weak operating cash flow?
Yes, a company can report very high net income in its income statement and still face cash problems if the collection of receivables is delayed or expenses are paid in advance. That is exactly why operating cash flow is considered a more reliable indicator of a company’s financial robustness compared to just the profit figure.
Improving Cash Flow Visibility and Control with Cheqly
By using Cheqly, a neobank, startups are able to enhance their cash flow visibility through real-time transaction tracking and a centralized business account for payment management. This allows businesses to obtain a transparent overview of cash movements in their operations, minimize payment delays, and have better control over their finances. Consequently, it leads to efficient cash flow management and well-informed financial decisions.
Sign up for a Cheqly business account to gain better control over your operational funds.