This guide looks closely at the definition of operating cash flow, why it's important, the different ways to calculate it and the advantages of other calculation methods.
What is operating cash flow?
Operating cash flow (OCF) quantifies the amount of cash generated by your company's usual business activities and the impact that cash has on your net income. It's the first section presented on a cash flow statement.
This measurement indicates whether your business can produce enough positive cash flow to maintain and grow without external financing, such as expansion capital.
Why is operating cash flow important in business?
Operating cash flow is important because it provides a clear picture of your business' ability to generate cash from its core business activities.
If your business isn't bringing in enough cash from its core operations, you'll need to find additional funding. While borrowing money or taking investments might relieve cash flow problems now, they aren't sustainable in the long term.
On the other hand, if your business has strong operating cash flow, this is a good sign – it means more cash is coming in than going out.
How to calculate operating cash flow (formula)
You can calculate operating cash flow using one of two formulas: direct or indirect.
While both formulas ultimately result in the same dollar amount, more people use the direct method because it clearly shows what cash is coming in and out.
Direct calculation
The direct method reports cash as it's paid or received. It's a straightforward way of preparing a cash flow statement, but it does require work to track and record all cash receipts and payments.
To calculate operating cash flow using the direct method, follow this formula:
Operating Cash Flow = Total Cash Inflows – Total Cash Outflows
Indirect calculation
The indirect method reconciles the difference between net income and operating cash flow by accounting for non-cash items and changes in working capital.
The formula starts with net income and adds non-cash expenses such as depreciation and amortisation because these expenses don't involve cash outflows. You then need to adjust for any changes in current assets or liabilities that affect working capital, and use this adjusted amount in your calculation.
To calculate operating cash flow using the indirect method, follow this formula:
Operating Cash Flow = Net Income + Depreciation and Amortisation – Net Working Capital
What is a good operating cash flow ratio?
A good operating cash flow ratio is over 1.0, meaning your business can cover all its expenses and debts with its existing cash flow.
Investors, creditors and analysts favour a higher ratio because it shows that your business can cover its current short-term liabilities and still have cash left over.
Operating cash flow examples
This is an example of operating cash flow using the direct calculation:
Cash Flow from Operating Activities
Employee wages and salaries: -$60,000
Cash received from customers: $350,000
Cash paid to suppliers: -$75,000
Income from interest: $15,000
Income taxes paid to ATO: -$30,000
Net cash from operating activities: $200,000
This is an example of operating cash flow using the indirect calculation:
Cash Flow from Operating Activities
Net income: $350,000
Depreciation: $150,000
Accounts receivable: -$50,000
Accounts payable: -$60,000
Net cash from operating activities: $390,000
What are the three types of cash flow?
The three types of cash flow that you should track and include in your cash flow statement are:
1. Operating
This type of cash flow includes all cash generated or consumed by a company's main business activities—including cash from sales, cash paid to suppliers, payroll, interest on debt and income tax payments.
2. Investing
This is the cash flow generated or used by a company when it buys or sells assets and investments.
3. Financing
This type of cash flow includes all money gained from issuing debt and equity, as well as payment of dividends and interest on debt made by the company.
Operating cash flow vs free cash flow
Operating cash flow versus free cash flow comes down to what they measure. Both methods can give you a comprehensive overview of your business's financial health and stability.
Operating cash flow
Operating cash flow only concerns what cash your business gets from core operating activities, so it doesn't account for capital expenditure.
Free cash flow
Free cash flow measures the amount of cash your business generates from core operating activities after deducting capital expenditure.
Positive free cash flow indicates that the company is generating more cash than it is spending on maintaining or expanding its operations, which is a sign of financial strength.
Free cash flow is calculated by:
Free Cash Flow = Cash from Operations – Capital Expenditures
Operating cash flow FAQs
Is operating cash flow the same as EBIT?
Operating cash flow is slightly different from Earnings Before Income and Taxes (EBIT) - also known as operating income.
Operating cash flow also accounts for interest and taxes in your company's everyday operations, which operating income doesn’t.
How much cash flow is good for a small business?
You should have enough to cover all your monthly expenses, with some in reserve. For a small business, your cash reserves should have enough cash to cover three to six months' expenses.
However, this may vary depending on:
Business stage
Access to funding
The state of the economy
Your industry and location
Goals and long-term growth plan
The products or services you provide
Number of staff and other operating expenses
Can operating cash flow be negative?
Yes, operating cash flow can be negative. You have negative cash flow if your outflows are greater than your inflows. While sometimes your business may spend more money than it receives and need to source funding, it’s not sustainable over the long-term.
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