Few metrics are as vital to the day-to-day health of your business as operating cash flow (OCF). OCF is essentially the lifeblood of your business — providing the working capital you need to maintain and grow your operations. In this guide, you’ll learn more about the importance of operating cash flow, how it’s calculated, and how to improve it.
What Is Operating Cash Flow?
Operating cash flow is the amount of cash you generate during the normal operation of your business.
Your cash flow statement may also include all three types of cash flow:
- Operating cash flow (OCF)
- Cash flow from investing activities (CFI)
- Cash flow from financing activities (CFF)
Your OCF will appear first on your cash flow statement. Investing and financing cash flow simply refer to cash generated from investing/financing activities outside of your normal business operations.
Operating Cash Flow vs. Free Cash Flow (FCF)
Is operating cash flow the same as free cash flow (FCF)? Not quite. Operating cash flow refers broadly to the money you generate from your day-to-day operations. Free cash flow does the same, but goes a step further by subtracting cash paid toward capital expenditures — that is, money allocated toward equipment upgrades or business improvements.
How to Calculate Operating Cash Flow
Operating cash flow can be calculated in two ways: the direct method and the indirect method.
Direct Method
The simplest way to calculate OCF is the direct method since it presents your business finances solely in terms of revenue and expenses.
Using this method, a business records all cash inflows and outflows during a designated accounting period. This can include:
- Cash received from customers
- Interest or dividends received
- Cash paid to vendors/suppliers
- Taxes and interest payments
- Payroll
You can calculate your OCF using the following formula:
OCF = Cash Revenue – Operating Expenses Paid in Cash
Positively, the direct method provides a crystal-clear snapshot of a company’s cash at any given time. On the other hand, businesses that rely on accrual basis accounting would be required to translate their financial records into the simplistic revenue/expense figures categories above.
Indirect Method
OCF can also be calculated using the indirect method, which adjusts a company’s net income to a cash basis and accounts for changes in non-cash accounts. These accounts commonly include:
- Accounts payable (AP)
- Accounts receivable (AR)
- Depreciation and amortization
This method is therefore ideal for companies that report their finances on an accrual basis.
Using the indirect method, OCF can be calculated using the following formula:
OCF = (Net Income) + (Depreciation and Amortization) – (Net Working Capital)
Net working capital (NWC) itself represents the difference between a company’s assets and liabilities.
The advantage of this method is that it favors businesses that rely on accrual basis accounting. However, it’s not as simple or transparent as the direct method, which could make it harder to communicate your business activity to stakeholders or lenders.
Why Operating Cash Flow Matters
OCF is one of the most important metrics for your business. That’s because your operating cash flow will give you a clear picture of the financial health of your company.
Your OCF can help you determine whether you have the cash on hand to cover your operating expenses or even invest in a new business project. And if you need a loan, most lenders will expect to see your operating cash flow along with your other key financial metrics when determining your eligibility.
Additionally, your OCF will provide a clearer, more accurate picture of your finances than revenue alone. For example, suppose that you complete a huge sale, but it takes a while to collect the money from the customer. Even if you record the sale as revenue, you won’t have access to the funds until you’re actually paid.
Ways to Improve Operating Cash Flow
How can you improve your operating cash flow? You can either increase the amount and speed of the cash you bring in or reduce the amount of cash flowing out of your business.
For example, you could improve cash flow by:
- Boosting sales with a promotional event
- Getting paid faster using electronic invoices and electronic payments
- Offering discounts for early payment
- Negotiating with suppliers for better rates and terms
- Staggering bill payments to avoid large cash outflows
- Offering multiple payment options to encourage fast payment
If late payments are a problem, you could also introduce penalties. Assessing a 10% fee for invoices paid after the deadline may encourage your clients to pay promptly, though you may have more success offering a small discount for clients who pay early.
Yes, this discount reduces the revenue coming in, but it gives you the cash in hand to meet your immediate obligations.
The Importance of Metrics
Understanding your business metrics can help you manage your business more effectively. OCF, revenue growth rate, net profit margin, and other metrics can help you track your key performance indicators (KPIs) and take control of your financial health.
Check out the other KPIs in our series below:
