Calculating Operating Cash Flow

Michelle Adams

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There are many ways to measure the financial health of a company. However, advanced accounting techniques and innovative ways of generating revenue can make some ways of assessing a business’s health inaccurate. That’s what so many business operators and investors use operating cash flow.

This article will look at operating cash flow. We’ll define what it is and explain why it’s so useful. We’ll give you the formula for operating cash flow and we’ll also provide an example. Use this information to make smart business and investment decisions.

What You Need When Calculating Operating Cash Flow

What is Operating Cash Flow?

Operating cash flow measures the cash produced or used by a business over a set period of time solely related to business core operations. That means that operating cashflow, or OCF, shows you how much cash flow a business’s core operations generate. It excludes revenue from things like investments or interest.

This is a very useful way of analyzing the health of a business. It only evaluates the core business operations. That has several important implications.

Understanding the Importance of Operating Cash Flow

The first benefit of using operating cash flow to analyze the health of a business is that it gives you a clear look at the business’s core operations. There are several reasons you’d want to get this information.

First, complex corporate structures, investments, and accounting techniques can mask how much money a business is actually producing. Including these assets in a business health analysis can cloud the picture of how well a business is actually doing.

This situation can make it hard to make informed decisions about running a business. It can also make it difficult to determine if a business is a good investment or not. That’s because other investments and interest payments don’t give meaningful information about how the business is performing.

As a result, business operators can’t make important decisions. You also can’t understand how efficiently the business is running. In addition to top level analysis, this prevents you from pursing further investigation. That means problems in various divisions or operations can go undetected. The longer these problems go undetected, the more difficult they’ll be to solve.

For example, you need to understand the cost of depreciating equipment to know the true costs of your business. If you fail to take depreciation into account, then you might find yourself facing unexpected expenses to replace valuable and essential machinery.

You can also use this formula to figure out how to make your business more profitable. For example, if the change in accounts receivable is hurting your operating cashflow, then you might offer a discount to customers and clients that pay early.

In the same way, if your accounts payable are interfering with having the operating cashflow your business needs, then you can start looking for ways to lower your bills. You might look for new suppliers. You might also negotiate better rates with your current suppliers. This situation can happen when a business grows. If you increase your production, but fail to renegotiate terms on your supplies, then you won’t be taking advantage of economies of scale. After all, the more you purchase from your suppliers, the lower you should be paying per-unit.

Calculating Operating Cash Flow

The Importance of Understanding Revenue Generated from Core Business Operations

The nature of investment and financing can be very complex sometimes. There are situations where investment in a company doesn’t entitle you to revenue generated from other interest or investments that company owns. Therefore, you might not see the return on your investment you’re expecting. You can even see a loss if the company is using other assets to pad their balance sheet.

It’s also important because it provides insights into the actual net income of a business. That’s because looking at a business’s cash expenses exclusively overlooks important aspects of the business. Most importantly, it helps show the role of asset depreciation in the health of the business.

This is especially important for businesses that rely on large, depreciable assets. Most manufacturing companies fall into this category. It also applies to companies with large real estate, buildings, and office furniture holdings. Companies don’t pay for depreciation with cash. That means that only looking at cash expenses doesn’t give you a complete picture of the business’s liabilities.

A Sign of Business Health – Key Info for Investors

Operating cash flow is one of the most important metrics of business health for investors. Investors like using operating cashflow as a way to measure a business’s health because it acts as a good predictor of how stable a business’s net income will be.

Income stability is an important consideration for investors. After all, investing in a company isn’t a decision to take lightly. You want to be sure that your investment produces predictable returns for an extended period of time. Companies with unstable net incomes aren’t as safe of an investment. One year they might produce outstanding returns. The next they might post huge losses. That complicates your ability to

Operating Cash Flow Formula

There are two ways to express the operating cash flow formula. They are called the direct method and the indirect method.

The Direct Method of Calculating Operating Cash Flow

The direct method of calculating operating cash flow is the simplest method. It doesn’t provide as much information as the indirect method. That means investors can’t use it to understanding vital aspects of the business. For example, you can’t learn anything about the company’s sources of cash. You also can’t get any operational data.

The equation for the direct method of calculating operating cash flow is:

Operating Cashflow = Total Revenue – Operating Expenses

As you can see, this simple equation will show you how much profit a business is generating. However, it doesn’t show you the vital components of the operating expenses. As a result, you don’t get the level of information that you’d want if you’re trying to make a decision about investing in a business.

The Indirect Method of Calculating Operating Cash Flow

The indirect method of calculating operating cash flow provides much more information about a business. In effect, it translates the operating section of an accrual income statement to a cash basis statement. The indirect method adds depreciation and amortization back into net income. It also adjusts to changes in inventory and accounts receivable. As a result, it provides a much more accurate assessment of the business. This is the reason that GAAP demands companies use the indirect method of calculating operating cashflow.

The equation for the indirect method of calculating operating cash flow is:

Operating Cashflow = Net Income +/- Changes in assets and liabilities + Non-Cash expenses.

As you can see, this equation also adjusts for changes in all non-cash accounts on the balance sheet. That means you can determine what the different sources of revenue for a business are. This formula also provides a better measurement of current trends in the company. That’s because it uses changes in assets and liabilities instead of total revenue.

Understanding trends is important when you’re making investment decisions. After all, most investors aren’t interested in short-term investments. They want to be sure that their investment will continue to produce stable, predictable returns. Any business can have an exceptionally good year. When you fail to take trends in a business’s assets and liabilities into account, then you don’t have a picture of how the company will perform.

For example, a company can issue bonds. These bonds generate revenue for the company. However, they’re not part of the business’s core operations. Also, continually issuing bonds isn’t a way to get sustainable business growth. Eventually, the bonds will lose value, lowering the amount of revenue they generate. Also, as the bonds mature, the payments on them will increase. By removing this type of confusing information from the picture, the operating cash flow equation shows how sustainable the business is based only on its core operations.

Calculating Operating Cash Flow

Operating Cash Flow Example

It’s always helpful to look at examples. An understandable example shows you how the concept is used in real life. It also shows you how to use the operating cash flow equation and apply it to your business.

For this example, let’s imagine a store that sells widgets. We’ll call it Wiggie’s Widgets. Wiggie is worried about a big-box widget store that opened up nearby and wants to see how their business can be improved. After all, the big box store has access to more resources. So, in order to stay competitive, Wiggie needs to get the most out of every possible resource.

In order to do this, Wiggie wants to look at the store’s operating cash flow. To do so, Wiggie will need the following information from year-end statements:

  • Net Income
  • Depreciation
  • Change in Accounts Receivable
  • Change in Inventory
  • Change in Accounts Payable

Net Income

In essence, net income is just your profit – what your business earned after all paying for all expenses. It assumes that all your accounts receivable to be paid already except when adjusted with allowance for bad debt.

Net income indicates that your business has grown financially during the recording period which is not always the case especially for new businesses. In some cases, it can also be net loss which means that your combined business expenses are bigger than your gross income.

Depreciation

Depreciation is the numerical interpretation of how much your asset has devaluated. While it is not something that you pay for with cash, knowing your depreciation costs allows you to know the true value of your asset as well as to prepare for future expenses once said asset needs to be replaced.

To know the cost of accumulated depreciation, follow this formula:

Accumulated Depreciation = Acquisition Cost – Book Value

If you’re going to prepare the books yourself, three popular ways of calculating for depreciation are the Straight Line Method, the Half Year Convention, and the Declining Balance Method.

Change in Accounts Receivable

As change in accounts receivable is the difference between the total value of your accounts receivable this year and last year, it is better to discuss what accounts receivable really is.

Accounts receivable basically contains all your clients’ debt to you. This means you have already fulfilled your obligations to those clients but have not received the payment yet.

Thus, a high positive change in accounts receivable is not always a good thing. If your sales numbers have not gone up by a lot, it can serve as a red flag to your investors because you have a low collection rate.

Change in Inventory

Change in inventory gives you a hint of how much of your goods you have sold during this year compared to last year. So, a negative change in inventory is normally a good thing.

The cost of purchasing your inventory changes from time to time, which is accounted for by applying the appropriate inventory accounting method: Last In First Out (LIFO), First In First Out (FIFO), or Cost Averaging.

Change in Accounts Payable

Because accounts payable is what you owe other entities (banks, other businesses, etc.), a negative difference on two year-end accounts payable statements indicates that you have been able to pay back your debt.

However, coupled with growing sales numbers, a higher accounts payable this year may only mean that your business is already catering to a bigger market.

This information contains all of the facts you need to understand your operating cashflow. It’s also structured in such a way that it gives insights you can’t get from other types of business analysis. Additionally, you’ll notice that we need the change, not the value of, the accounts receivable, inventory, and accounts payable. This will help you analyze trends in different parts of your core business functions. After going through the books, Wiggie comes up with the following numbers:

  • Net Income: $100,000
  • Depreciation: $10,000
  • Change in Accounts Receivable: +$50,000
  • Change in Inventory: -$20,000
  • Change in Accounts Payable: -$20,000

Using this information, the equation looks like this:

  • Operating Cashflow = $100,000 – $50,000 +$20,000 – $20,000 + $10,000
  • $60,000 = $100,000 – $50,000 + $20,000 – $20,000 + $10,000
  • Operating Cashflow = $60,000

This shows that Wiggie’s Widgets produces $60,000 in cash flow from operations after the bills get paid. Wiggie can take this information and find ways to grow the business. This might be increasing the marketing budget, purchasing new machinery or equipment, investing in new software or personnel, or anything else Wiggie feels will make the business more profitable. The store could pay money out to shareholders in an effort to bring in more investment.

No matter what Wiggie decides to do, the information shows that the widget business is doing well enough to grow. That’s important information. It also gives the ability to start to budget so that Wiggie can start planning the best ways to grow while still generating enough profit to satisfy investors.

Additionally, for investors, this equation shows valuable information. First, it shows that the company is generating a profit. It also demonstrates how much of a profit the business creates.  It also gives a more accurate picture of their net income. That’s because companies don’t pay for the depreciation of assets with cash.

In Summary: Operating Cashflow

As you can see, there are lots of reasons why it’s important to calculate your operating cash flow. It’s one of the only ways to get investors to be interested in your business. It’s necessary to effectively plan for your business and its needs. It helps you keep track of the deprecation of your assets. It also helps you understand how asset depreciation affects your actual operating profit.

This information doesn’t only show you where your business is weak. It also shows you where your business is strong. For example, if your revenue is up and your accounts receivable is down, you know that you’re doing a better job of collecting money faster. You can use that information to adjust your budgeting and planning for growth. You can also use it to plan dividends to attract investors.

Operating cashflow is an effective measurement of business efficiency. It tells you how well your core business operations are functioning. It also prevents deception from revenue that isn’t part of your normal business operations. Therefore, you get a more accurate picture of the trends in the business than looking at net income alone can provide.

Use this information to grow your business. Or you can use it to make informed decisions about where you should invest your money. No matter what your goal is, you can get vital information about a business by calculating its operating cashflow.

FAQ

If you own a business, your operating cash flow is one of the most important aspects of your company’s financial health. While it is an extremely vital component of any business’s accounts, many business owners don’t fully understand operating cash flow and how it works.

In this section of our website, we take a look at some of the common questions we receive about operating cash flow and related subjects. If you own a business, or plan to in the near future, make sure to check out the questions below!

General Cash Flow

If you have general questions about operating cash flow, this is the section for you. Check out our most commonly asked questions below!

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What is included in operating cash flow?

Operating cash flow includes any cash that you receive from typical business operations. In essence, it’s the amount of revenue you can expect to generate during normal business practices.

Operating cash flow also factors in depreciation, accounts payable, and accounts receivable. This makes it a reliable measure of a company’s health.

What is net operating cash flow?

Net operating cash flow is an adjusted amount of money that determines how much cash flow a business has. It provides a context for the health of a business. A business with an operating cash flow can typically invest in operations and expansion.

What is the OCF?

OCF is a simple abbreviation for operating cash flow. You may see cash flow expressed as OCF in various different places.

Where do you find operating cash flow?

To find the operating cash flow of a company, you typically need to look at the corporate cash flow statement. Business’s should provide these statements.

What is operating cash flow statement?

An operating cash flow statement is a financial statement that outlines the operating cash flow of a company. It will detail all of the financial information included in the operating cash flow.

What is the difference between cash flow and net income?

Net income uses the accrual accounting method to calculate revenues minus eligible expenses. On the other hand, cash flow is usually determined by differences in the amount of cash within a business on certain dates – typically the last day of the reporting period.

What is the difference between operating cash flow and free cash flow?

To find free cash flow, you take net income plus depreciation and amortization, and subtract the change in working capital and capital expenditures. To find operating cash flow you do the same thing, except you don’t factor in capital expenditures.

How do you do a cash flow forecast?

Cash flow forecasting can help you predict how much cash flow your business will have. There are plenty of online templates and resources that allow you to easily calculate your cash flow forecast. Many people use pre-made excel templates to analyze cash flow forecasts.

Why is operating cash flow important?

Operating cash flow is important because it provides business owners with an understanding of how healthy their business is. Without operating cash flow, you won’t be able to pay your bills or invest in your company. This type of cash flow is undeterred by some account methods that restrict net income.

Is operating income the same as EBIT?

No, EBIT is different from operating income in certain circumstances. Many sources say that EBIT and operating income are the same thing. But there are certain instances in which they will differ.

Is depreciation included in operating cash flow?

Yes. Depreciation is typically included in operating cash flow, though this is not always explicit.

What is terminal cash flow?

Terminal cash flow is the cash flow that a company receives after the finalization of a project. Typically, this will include the post-tax revenue from the disposal of the assets involved in the project. It will also include how much is returned in working capital.

Is interest expense in operating cash flow?

No, interest expense is typically not included in the operating cash flow formula for small business owners.

What is the cash flow from assets?

The cash flow from assets is the amount of cash flow a business receives from its assets. This cash flow can be generated from a wide variety of different assets. Such as renting out a commercial property to a customer.

How do you find operating cash flow?

To find operating cash flow, you should look at a company’s cash flow statement. This statement will include all the necessary numbers associated with operating cash flow.

What is OCF in funds?

OCF is the amount of funds that a business receives through normal operations. OCF is the acronym for Operating Cash Flow.

Is cash flow revenue or profit?

No. Cash flow is the amount of cash (revenue) that your business is able to turn over. It doesn’t actually indicate how much profit you make. Profit takes various other components into consideration, including taxes and other expenses.

Is net operating income the same as cash flow?

No. Net income is the difference between income and expenses. Operating cash flow also includes change in working capital. It’s also important to know that operating cash flow factors in noncash expenses.

What is operating cash flow ratio?

To find your operating cash flow ratio, you need to divide your current cash flow by your current liabilities. This is a good way to gauge the health of your company’s financial situation.

How can cash flow be improved?

The best way to improve your cash flow is to take a look at your operations and seek to enhance them. You should consider sending out invoices faster, improving revenue, and marketing your products or services more efficiently. The best way to improve your cash flow is to improve your business.

What is a positive cash flow?

Positive cash flow means you have more money coming into your business than going out. If you want to run a business successfully, it’s vital that you have positive cash flow.

What is cash flow analysis?

Cash flow analysis is the process of looking at cash flow to determine the health of a business. You will analyze the cash inflows and outflows to help decide if there are ways you can improve your current cash flow situation.

What are the types of cash flows?

There are three types of cash flow: operational cash flow, financing cash flow, and investment activity cash flow. Operational cash flow is the cash flow you receive from normal business functions. Financing cash flow is the cash flow you receive from loans or other forms of financing. And investment activity cash flow is the type of cash flow that originates from any investments made by your business.

How can small businesses improve cash flow?

A small business can do a variety of different things to improve their cash flow. First, they may want to consider improving their current products or inventory. Billing more efficiently can also improve cash flow. If you’re not marketing your products correctly, using better marketing techniques will likely allow you to improve your cash flow.

Are dividends received as operating cash flow?

This will depend on the scenario. In some cases, this will be viewed as investment activity cash flow. In other cases, this will be viewed as an operating cash flow.

Are long term debts paid in operating cash flow?

You can pay your long-term debts with operating cash flow if you wish. Typically, debt will not have a particular form of funding that you need to use to finance the repayments.

Is EBITDA the same as operating cash flow?

No. While many people view these as the same thing, they’re not. Operating cash flow considers changes in working capital accounts. While EBITDA factors in interest expenses and income tax expense – operating cash flow does not.

Calculating Cash Flow

If you want to calculate cash flow, it’s essential that you understand the formulas and basic concepts. Check out our most popular questions about calculating cash flow below!

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How do you calculate operating cash flow?

If you want to calculate operating cash flow, you need to determine net income and then factor in noncash expenses and changes in working capital.

What is the formula for operating cash flow?

The basic formula for operating cash flow is ‘Net income + changes in working capital + noncash expenses.’

How do we calculate cash flow?

To calculate cash flow, we find the net income of the company and subtract current expenses and add changes in working capital.

What is the cash flow equation?

Cash flow equation: net income + noncash expenses + changes in working capital. 

What is the formula for free cash flow?

The formula for free cash flow is slightly different than the formula for operating cash flow. To find free cash flow the formula is: operating cash flow – capital expenditures.

What is the direct method of cash flows?

The direct method of obtaining cash flows is different than the traditional accrual method. The direct method is also known as the income statement method. In this method, the real amounts of cash income are used to calculate cash flow, rather than the accrual method.

How do you determine cash flow?

To determine cash flow, you should take you net income, subtract your current noncash expenses, and add your changes in working capital.

How to calculate operating cash flow in excel?

If you want to calculate operating cash flow using Excel, you’ll be pleased to know there are some great templates online that are available for free. Instead of setting up the formulas manually, you can download an operating cash flow document via the internet and import it into excel.

How to find cash flow from operating activities?

To find cash flow from operating activities, you first need to determine your net income. You then subtract noncash operating expenses and add adjustments in working capital.

How to calculate operating cash flow from income statement?

Calculating cash flow from an income statement is the same as calculating operating cash flow – it’s just another way to describe it. You should take net income, subtract noncash expenses, and add changes in working capital.

How to calculate operating cash flow from balance sheet?

You can’t calculate operating cash flow differently using a balance sheet. You still need to take net income, subtract noncash expenses, and add your adjustments in working capital.

How to calculate after tax cash flow from operations?

Calculating after tax cash flow is simple if you know how to calculate your operational cash flow. Once you determine operational cash flow, subtract the total of your taxes from the operating cash flow.

How to calculate operating cash flow per share?

To calculate the operating cash flow per share, you simply need to divide the current amount of operational cash flow by the total number of shares. It’s a very straightforward process.

Other Cash Flow FAQs

If you haven’t found the answers for your cash flow questions in the above sections, you’ll probably have more luck in the section below! Check out our other cash flow questions in this section.

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Does interest expense affect operating cash flow?

Yes, it does. But under the operational cash flow method, interest expense is already associated with your net income. Regardless, it does affect operating cash flow for your business.

Is R&D a cash flow from operating?

No. Typically R&D is an expense as you have to pay money to research and develop products or services that may not come to fruition.

How could net income increase while operating cash flow decreases?

Net income increases while operating cash flow decreases if other components of operating cash flow decrease. Remember, net income is only one component of operating cash flow.

Is security deposit operating cash on cash flow statement?

A security deposit will actually decrease your operating cash flow – not increase it.

How to estimate cash flow from operations?

Estimating cash flow from operations is complicated and requires in-depth financial analysis knowledge. To estimate cash flow from operations, forecasters look at previous operational cash flow and factor in current variables to determine what type of cash flow to expect.

What is the annual operating cash flow?

The annual operating cash flow of a business is the total operating cash flow a business has throughout a financial year.

Why are cash dividends operating cash flow?

Cash dividends are operating cash flow because they represent cash income that a business receives. Businesses can then use this cash income to reinvest in their business or pay for further operations.

How to increase operating cash flows using the asset structure?

If you want to increase your operating cash flow using the asset structure, it’s essential to understand the type of income you can generate from your assets. You should try and generate more efficient income from your current assets. For example, if you don’t lease out your current commercial property on the weekends, you may be able to generate additional cash flow from this asset.

How changes in inventory affects cash flow from operations?

If you improve your inventory, there’s a high chance you can increase your cash flow from operations. Many business owners seek to improve their cash flow from operations using improved inventory.

Are pensions included in operating cash flow?

Not always. There may be some cases in which a pension is considered financing cash flow instead of operational cash flow.

Why do organizations prepare cash flow statements and operating statements?

The reasons that organizations prepare these statements is because of how vital this information is to the health of their companies. If you don’t have good cash flow, you will eventually run out of business. Organizations need cash flow to fund different activities, including expansion and current operations. Don’t underestimate the power of these statements – they’re a great way to check the current output of your company.

What is negative cash flow from operations?

Negative cash flow from operations is when you have more cash loss than cash income. If you have negative cash flow from operations, this is a clear sign that your business is not operating correctly.

Is paid cash for rent operating activity cash flow?

Yes. If you rent a property out to a client, the income from that property will most like be factored into your net income, which will affect your operating cash flow.

Does bad debt expense impact operating cash flow?

Yes. If you have bad debt expenses from debt your business has taken on, this will most likely impact your operating cash flow. Make sure to consider it when you’re trying to determine your operating cash flow.

How to improve negative cash flow from operations?

If you want to improve negative cash flow from operations, you need to start operating your business better. Negative cash flow is a clear sign of a problem – if its left unfixed, it will continue to create problems for the business owner and eventually run the company out of business. Consider different ways you can use your current assets and operations to improve cash flow. Improve you inventory, improve your marketing, target customers more efficiently, and increase your output. There are plenty of different ways you can improve your current cash flow.

As you can see, operational cash flows are very complicated. This is not an easy subject to understand. If you’re trying to calculate your operational cash flow, it’s essential that you do it correctly. Business owners that better understand the value of operational cash flow are more likely to be able to assess the health of their businesses.

If you need more information on this subject, make sure to check out some of the other resources on our site!

Michelle Adams
Business Consultant

Michelle worked at a teller at her local bank while she was earning her degree in economics. Then, after completing an MBA, she came back to the bank as a loan officer. As a result, Michelle is uniquely suited to providing advice to small businesses when it comes to selecting the best loan and credit products.