Definition: Operating cash flow is the amount of cash a business generates from its operational activities. This metric reveals if your company’s operations are enough to sustain and grow your business, or if additional investment or financing measures are required.

What Is Operating Cash Flow (OCF)?

The cardinal rule of business is to not run out of money. So it’s not surprising that small business owners find themselves poring over their profit and loss statement. After all, everyone knows if you’re not turning a profit, you won’t be around long.

But plenty of businesses have found themselves facing bankruptcy after a record-profit year. How is this possible?

The answer is poor cash flow management.

To truly assess the financial health of your business, you need to pay as much attention to your operating cash flow statement as you do to your profit and loss statement.

For example, an increase in sales may not translate into bigger cash flows if you’re also carrying a high accounts receivable balance.

We’ll go through the meaning of operating cash flow, break down the formula and walk through an example, so you’ll have the tools to make sure there’s enough money in the bank to sustain your operating costs and grow.

Net Income vs. Operating Cash Flow (OCF): Know the Difference

Many new business owners hear the term “operating cash flow” and assume it means the same as “net income” or “net profit.” Although the two terms are related, they’re actually quite different.

In fact, you can report a net profit without being cash flow positive. Let’s take a closer look at how this is.

Net income is a big picture number. It’s calculated by subtracting total expenses from revenue.

In other words, net income is the measure of whether a company made money during a period of time. But what it doesn’t tell you is when those inflows and outflows of cash are occurring. Thus, it’s not a clear indicator of your business’s day-to-day financial well-being.

To illustrate this point, consider this example:

Company A and B report the same net profit. However, Company B routinely experienced cash shortfalls and did not have enough money to cover rent or make payroll. The reason? Company B collects its accounts receivables significantly slower than Company A and therefore has lower operating cash flows.

As this scenario proves, the financial trajectory of your business may be strong, but if you struggle with the timing of income relative to expenses, you may find yourself in hot water.

In fact, it’s the number one reason why small businesses fail.

According to SCORE, 82 percent of failed small businesses cite “poor cash flow management skills/poor understanding of cash flow” as a contributing factor.

How to Calculate Operating Cash Flow

Now that we’ve answered what operating cash flow is and why it’s important let’s break down the operating cash flow equation.

Operating Cash Flow Formula

If you’ve never calculated cash flow from operating activities before, use this formula:

Operating Cash Flow = Net Income + Non-cash Expenses (Depreciation & Amortization) +/- Changes in Working Capital

Understanding the Components of the Operating Cash Flow Formula

Net Income

What It Is: As discussed previously, net income represents the amount of money after all expenses have been deducted from a company’s total revenue.

Every operating cash flow calculation starts with the net income, but because it includes items that do not affect cash, such as depreciation and amortization, adjustments must be made.

Non-cash Expenses

What It Is: Non-cash items are entries on an income statement relating to expenses that are essentially just accounting entries rather than actual movements of cash.

Depreciation and amortization are the two most common examples of non-cash items. Though assets do lose value over time, your company does not write a check to “Depreciation.” It is just an accounting entry to reflect the reduction in asset value. Therefore, you need to add this expense back into net income to calculate operating cash flow.

Changes in Working Capital

What It Is: Working capital is the difference between a company’s current assets, like accounts receivable and inventory, and its current liabilities, like accounts payable.

Any increase in assets must be subtracted out while a decrease in assets must be added back in. The opposite is true for liabilities. Increases are added back while decreases are subtracted out.

For example, if you can negotiate longer repayment terms with your vendors and suppliers, your accounts payable balance will increase. This is a positive for cash flow.

Now that we know how to calculate operating cash flow let’s look at a basic example.

Operating Cash Flow Example

Jessica Smith is a bridal coordinator.

  • She is showing $125,000 in net profit.
  • She has $75,000 in uncollected debt from her customers.
  • And, she owes $15,000 to her suppliers.
  • In addition, she bought a company vehicle two years ago and intends to use it for the next five years. So, she has a depreciation expense of $6,000 per year.

Jessica’s operating cash flow statement looks like this:

Net Earnings $125,000
Non-cash Expenses:
Plus: Depreciation & Amortization $6,000
Changes in Working Capital:
Less: Accounts Receivable ($75,000)
Plus: Accounts Payable $15,000
Cash Flow from Operations $71,000

As you can see, Jessica was able to generate $71,000 of cash flow from her operations.

It shows Jessica’s core business activities are successful enough to sustain the business with enough left over to invest in initiatives to fuel company growth.

It’s important to note, operating cash flow is just one component of a company’s cash flow statement. To get a true measure of your available cash flow, you must also factor in costs associated with the investment (purchase or sale of assets not related to day-to-day operations) and financing (owner’s draw/payments against a business loan) activities.

Jessica:

  • Spent $12,000 on equipment
  • Paid $25,000 against various business loans.

As a result, her complete cash flow statement looks like this.

Net Earnings $125,000
Plus: Depreciation & Amortization $6,000
Changes in Working Capital:
Less: Accounts Receivable ($75,000)
Plus: Accounts Payable $15,000
Cash Flow from Operations $71,000
Less: Investment in Equipment ($12,000)
Cash Flow from Investing ($12,000)
Less: Loan Payment 1 ($15,000)
Less: Loan Payment 2 ($10,000)
Cash Flow from Financing ($25,000)
Ending Cash $34,000

What Does Operating Cash Flow Tell You

The goal of any business is to make a profit. And to do that, cash flow from operations should be positive. A few months of negative cash flow from operations isn’t always a big deal, but you want this number to be positive as often as possible for your company to remain solvent.
By examining your cash flow statement on a routine basis, you can take swift action to remedy any shortfalls. Ideas include:

  • Buying less inventory if adequately stocked
  • Negotiating with vendors to pay later
  • Shortening accounts receivable terms
  • Raising prices
  • Obtaining cash flow loans to cover temporary shortfalls

Isolating and honing in on the well-being of your day-to-day operations is one of the most important actions you can take as a small business owner. And the best part is, there are many resources available to help you get your cash flow analysis off the ground.
Most accounting programs have built-in tools to help you create a statement of cash flow. What’s more, you can find calculators, articles and templates at the U.S. Small Business Administration and SCORE websites to get you started.