In the digital era, every small or large business is concerned about its financial health as it aims for long-term success and improved cash flows. However, many businesses failed to achieve profit margins, citing cash crunch as their main cause of failure. Therefore, you must keep an eye on cash flows if you really want to turn profits.

Operating cash flow can reveal whether your company is generating cash inflows or requires more funding to achieve the profit.

Sometimes you do profitable business but fail to pay fixed or variable expenses on time. In this scenario, you might be running out of cash but may not know. It could be the result of untimely payment from customers that can negatively influence operating cash flow regardless of more or less product sales.

Here, we have a comprehensive guide on how to calculate OCF using the right operating cash flow formula to help you overcome cash shortage and achieve the desired profit.

What is Operating Cash Flow (OCF)?

Operating cash flow (OCF) is the process of measuring how much cash is generated by your business operations like services offered, product sales, and marketing activities. It helps you figure out if you generate sustainable revenue or require more sales in order to achieve business profitability.

Basically, it depicts a company’s ability to convert spending into profit. In case the operating cash flow is negative, your business needs extra funding to keep daily operations up and running. OCF is considered as part of the cash flow statement, which will be required to determine cash inflows and outflows in the income statement.

How to Calculate the Operating Cash Flow

Operating cash flow calculations can be done using two methods, indirect and direct methods.
Before we move on to how to find operating cash flow using these methods, let us know the formula for operating cash flow.

[Total Revenue Output + Non-cash Expenses] – Net Working Capital (NWC) = Operating Cash Flow

Indirect Method

Despite being a more complex OCF calculation method, the indirect method is a top pick for modern businesses.

For calculating OCF using the indirect method, you need to figure out total income and add non-cash charges like accounts payable (AP), accounts receivable (AR), and depreciation. Thereafter, determine overall working capital subtracting liabilities from current assets. It is the leftover amount that can be used for business short-term expenses.

Operating Cash Flow Formula (Indirect method):

Net Income + Depreciation and Amortization – Working Capital Changes = OCF

If AR is higher, then you have incoming cash flows, as per accrual basis even though you didn’t receive the cash. AR should be separated from your net earnings as it negatively impacts cash transactions. Whereas, if you found AP higher, then business expenses are reported on an accrual basis but are yet to be paid. This increased AP must be added to the net earnings to check the impact of cash.

Direct Method

Another method to calculate OCF is the direct method, which is much easier than the indirect method as there are less factors to consider such as cash inflows and expenses paid through cash. The direct method aims to uncover a clear picture of cash movement in the specified period. Here, cash inflows are money paid by customers and expenses are staff salaries, vendor payments, or taxes.

Operating Cash Flow Formula (Direct Method):

Revenue generated from sales – cash paid for business operations = OCF

Notably, a direct method is simple to use but may not provide an accurate outcome if the given data is from a different accounting period. Whereas, an indirect method is more reliable and can aid you in identifying problems with cash flows.

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Why is Operating Cash Flow Important?

It is an important metric for any entrepreneur or business owner looking to get the bigger picture of their business profit earned in reality. Operating cash flow unveils whether the company is in a strong position to clear its debts or any other expenditures related to daily operations. Also, it is mainly used for identifying if businesses will need any additional funding to run business activities.

As a business head, when you dive deep into these metrics, you will uncover the company’s real economic benefit. Suppose if you have adequate sales numbers but don’t generate sustainable revenue to run the business, then something is wrong with the cash flow. Such issues with the cash flow can be picked by operating cash flow (OCF).

Furthermore, think from the investor’s point of view. Imagine if you are an investor, then you would only consider those companies that have stable growth and a better OCF. Similarly, any investors will assess whether your company is good enough to make ROI before putting their money.

Forget about others, recall the business owner’s perspective. When you stepped into the owner’s shoes, you likely set up goals. Will you be able to generate profits to fulfill those financial goals?

And that’s why tracking OCF is important to learn how soon you will achieve the target or what necessary changes are required in the business operations.

Operating Cash Flow Vs Net Income

While OCF and net incomes together contribute to your income statement, it is confusing to understand how these two differ from each other. Let’s find out in detail.

Operating Cash Flow Net Income
It shows the actual profit earned over the specific period The total amount received by your company
OCF will be adjusted as per pending payments Payment delays do not affect net income
It is highlighted in the first section of the statement Net income appears in the bottom part of the income statement
Operating cash flow can be generated from net income It can be obtained by subtracting business expenses and COGS (cost of goods sold).
OCF helps to identify whether the company can repay debts Net income doesn’t offer insights into business profitability.
It is usually lower than the net income Net income can be higher in amount
OCF formula:

[Revenue + Non-cash Expenses] – NWC = Operating Cash Flow

Net income formula:

Revenue – COGS – taxes = Net income

Operating Cash Flow Example

Let’s say you are assigned a task to calculate your company’s OCF. The first thing you will need is net income, which is $200,000 you receive by billing customers. Second is expenses paid for business activities such as employee training, buying materials, or running paid ads on Google.

Assuming this operational expense is $9000. Other than that, you need net working capital that is $30000 and depreciation cost amounting to $4000 for the specific accounting period.

Now, since we have all the details, let’s plug them into the operating cash flows formula:

$200,000 + $4000 – $9000 – $30000 = $165,000 (OCF)

So, at first glance, you would have thought of earning a profit up to $200,000. But, in reality, it’s not. Here, we found $165,000 as an OCF, which depicts the actual profit you made during a fiscal year.

Conclusion

Operating cash flow (OCF) plays a significant role in measuring profitability. It is the metric to help businesses learn their ability to earn profit from their regular operations. If you are running a small or medium-sized business, then you are likely to need to calculate operating cash flow at some stage. Not only to complete the income statement but also to analyze net earnings and cash outflows. So, whenever OCF is required, you can simply follow the above steps and figure it out.

As far as profitability is concerned, analyzing the business metrics isn’t just enough. You need to automate business operations like accounting and expense tracking. Moon Invoice, a cloud-based accounting software, can help you transform your business by automating administrative tasks like generating invoices, receipts, and expense reports. As a result, you can invest more time in developing strategies that drive sustainable revenue.

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