Understanding Operating Cash Flow

Cash flow is one of the most important concepts a small business owner can understand—in some cases, experts believe cash flow can be more important than profit in judging the viability of a business. In very basic terms, cash flow is a measure of how much money is flowing into your business, like through sales, versus how much is flowing out, such as through expenses.

Operating cash flow (OCF) is a way of further defining business cash flow. The operating cash flow formula is based on how much money is flowing through your company’s bank accounts under normal conditions—that is, your everyday operations.  

Understanding your operating cash flow is important because it can help you know if your business needs outside funding, like from a bank or an angel investor, to maintain operations.

What Is the Net Operating Cash Flow Formula?

Operating cash flow is operating income plus non-cash expenses minus increase in working capital.

Before you can calculate using this OCF accounting formula, you have to know your company’s operating income. Operating income is a way to express how much profit is earned from a business’s operations while taking into account certain expenses.

To calculate your operating income, start with your company’s revenue for a given period, like a fiscal quarter or year. Subtract your cost of goods sold (COGS), the direct expense paid for each good sold, from your revenue. COGS is the cost of manufacturing or acquiring your goods. For service-based businesses, your COGS could be the costs of a “unit” of service, like direct wages.

COGS, importantly, do not include indirect operating costs like rent for a storage unit. This number, revenue minus COGS, is known as your gross operating income.

After subtracting COGS from your total revenue, subtract all of your business’s other operating expenses, like raw materials, salaries, rent, and office supplies. Do not subtract non-operating expenses, like taxes. This number is your operating income.

Add in your non-cash expenses like depreciation expenses and stock-based compensation.

After this, subtract increases in working capital. Working capital is the difference between your company’s current assets and current liabilities.

What Is the Meaning of Working Capital?

Understanding working capital is critical for calculating OCF. Working capital gives you an understanding of your company’s short-term liquidity.

Subtract your liabilities, like debt repayments, from your assets, like your property, to calculate your working capital. This working capital can increase or decrease over time, which is when you use it to adjust your OCF formula.  

If your inventory increases on your balance sheet, for example, this means your cash is reduced. Accounts receivable increases also raises your working capital because it means you earned revenue but have not yet been paid in cash due to an outstanding invoice.

Working capital can also decrease, which would result in you adding it to your operating income and non-cash expenses in your OCF formula. An increase in accounts payable means that you incurred expenses but have not yet paid them, therefore it increases your cash flow in the moment.

Determining Your OCF

At this point, you have determined your OCF, which can be either positive or negative. If it is positive, that means you are earning cash over the specific period. If it is negative, you are losing money.

There is also a direct method to calculate operating cash flow, but it is not allowed by General Accepted Accounting Principles (GAAP) unless it is accompanied by an indirect version of the OCF formula as described above. In the direct method, you adjust your operating income by the actual amounts you pay and earn in cash in a specified period—there are no accounts receivable and accounts payable in this method of a cash flow formula, for example.

You can calculate operating cash flow in Excel and other software programs. The Small Business Administration has several great templates. The Lendio app has a cash flow tool and a cash flow reporting feature, making this process very user-friendly.

What Is an Example of a Cash Flow?

Let’s say your company earns $50,000 in a month in cash payments and has $30,000 in cash expenses for that time. You have no depreciating expenses, like property. Over that month, your working capital increases because you have another $3,000 in accounts receivable; however, these invoices are outstanding and remain unpaid at the moment.

Following the OCF formula, your OCF at the end of the month is $17,000.

OCF and Funding

By understanding your company’s OCF, you can see how much cash your company is earning or losing on its own. With this data, you can see if an increase in cash from an outside source, like a lender, could help your business expand in the way you want it to.