Your business has been profitable for the past two years, yet you sometimes have trouble paying all the bills on time. What’s going on?
After some review and examination, you see sales have been growing, but collections are lagging—more customers are taking longer to pay, even as you pay your suppliers and vendors promptly. That means the business, even if it’s profitable, sometimes has a cash crunch or some problems with its operating cash flow.
What is operating cash flow?
Operating cash flow is an accounting measure that tracks the amount of money received and paid by a company. It’s an essential way to gauge a company’s ability to generate enough cash to operate without the need for outside financing from loans, bonds, or stock offerings. In other words, operating cash flow is more about a company’s liquidity than its profitability.
How to calculate operating cash flow
There are two main ways to calculate operating cash flow: the direct method and the indirect method. Most businesses prefer the indirect method because it allows them to reconcile their income statement with their cash-flow statement and to account for differences between the two. It shows the interplay between profitability and cash flow.
Indirect method
The indirect method starts with a business’s income statement. It then adds back any noncash charges, such as depreciation and amortization of assets (depreciation is for tangible assets, amortization is for intangible). Then any year-to-year change in net working capital, from the balance sheet, must be included. The indirect formula is:
OCF = net income + depreciation and amortization - change in working capital
Net working capital is a business’s total current assets minus current liabilities. These are amounts received or paid during a company’s current business cycle, which is typically one year.
Current assets include things such as inventory (unsold goods) and accounts receivable, and current liabilities include accounts payable, short-term debt, and taxes due.
Net working capital is how much money a business has available to pay short-term expenses, or those coming due within the current year. It is tracked from year to year to see if it has increased or decreased. An increase represents a net reduction in cash because more cash was spent to buy current assets such as inventory. A decrease in net working capital means the opposite.
Direct method
The direct method tracks only cash transactions in a given period. Cash income includes money collected from customers, and interest or dividends received. Cash payments include wages and salaries, payments to suppliers, and interest and taxes paid. The direct formula is:
OCF = cash sales or revenue received - cash paid for operating expenses
Example of operating cash flow
As an example of how credit sales can affect operating cash flow, let’s say Company A reports $1 million in sales, $500,000 in expenses, and $100,000 in taxes for the year. A quarter of those sales, $250,000, aren’t yet collected, because customers have 60 days to pay, so only $750,000 in cash sales are recognized. Here is how net income and operating cash flow would compare for the year:
| Net Income | Operating Cash Flow (OCF) | |
|---|---|---|
| Sales | $1,000,000 | $750,000 |
| Expenses: | -500,000 | -500,000 |
| Taxes: | -100,000 | -100,000 |
| TOTAL: | $400,000 | $150,000 |
After comparing these, Company A might conclude it needs to collect faster on credit sales, or perhaps delay paying some of its expenses, to bring operating cash flow more in line with net income.
Operating cash flow vs. net income
Businesses evaluate operating cash flow alongside net income to see if profitability and cash generation are moving in the same direction (presumably upward), or if they are diverging—and to understand why.
Operating cash flow and net income might seem like the same thing—both are concerned with tracking the movement of money. The key distinction between operating cash flow and net income (profit) is the accounting methods used for income and expenses. Net income uses the accrual method, which records sales and expenses when transactions or production occur, even if cash wasn’t received or paid. This means some items in a company income statement can be noncash. Operating cash flow counts only cash as it’s received or paid out.
How are they similar?
Each is an essential measure of a business’s financial health. Net income gauges strength based on profitability, while operating cash flow is more concerned with liquidity—the day-to-day ability of the business to pay recurring expenses from sales or revenue.
How are they different?
Although both measures gauge a company’s financial condition, there are important differences.
- Net income is based on the accrual method of accounting, which makes assumptions about the timing of some income and expenses, regardless of when money is received or paid in the financial year.
- Operating cash flow uses cash accounting, which tracks only actual receipts and payments of money in the financial year.
A company’s operating cash flow can be more or less than its net income, depending on its circumstances. Slower collections from customers at one company might be the cause of cash flow lagging behind profit, while at another company with large depreciation charges, operating cash flow might exceed net income.
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Operating cash flow FAQ
How do you calculate OCF using the indirect method?
The most common way to calculate operating cash flow is with the indirect method, because it draws indirectly from the income statement and balance sheet rather than the cash-flow statement. The calculation for the indirect method of operating cash flow is:
OCF = net income + depreciation and amortization - change in working capital
What is the difference between cash flow and operating cash flow?
A company’s cash flow consists of three parts: operating cash flow, investing cash flow, and financing cash flow. Operating cash flow is the most important because it indicates whether the company has a viable business that generates enough cash to pay all expenses, with some left to pay dividends or expand. Investing cash flow reflects the buying or selling of assets used in the business, and financing cash flow reflects the receipt of any money from outside funding sources, typically used to purchase assets, and payments to those sources, such as dividends and debt repayment. The cash flows from operations, investing, and financing are tallied to calculate a company’s total cash position, or net cash. Businesses evaluate their net cash from year to year, along with their profitability. Is cash flow
Is cash flow from operations the same as operating profit?
Operating profit includes depreciation and amortization, but excludes interest and taxes. Cash flow from operations does the opposite: it excludes depreciation and amortization because they are non-cash expenses, and it includes interest and taxes because they are cash expenses.
How is free cash flow different from operating cash flow?
A company’s free cash flow is its operating cash flow, minus any capital expenditure the company deems necessary to maintain the operating efficiency of its assets. Free cash flow, therefore, is the excess money from operations after such maintenance spending that the company is free to spend as it chooses—to expand, to repay debt, or to pay stock dividends. It is a measure of a company’s ability to rely on its own resources without outside financing.
