A striking 82% of small businesses collapse due to mismanaged cash flow, not lack of profit. What, then, is the essence of operating cash flow? In this exploration, we’ll dissect cash flow analysis and provide you with the tools to adeptly calculate operating cash flow, fortifying your business against financial pitfalls.
Operating cash flow (OCF) is the money produced by a company’s day-to-day operations, reflecting its ability to maintain and grow its operations. It represents the cash that flows in and out of a business from its core operations, such as sales, inventory purchases, payment of wages, and taxes. OCF is a key financial metric used by analysts, investors, and management to evaluate a company’s financial health and performance.
The main components of operating cash flow are revenues and expenses. Revenue represents the cash generated from sales, while expenses include all the costs associated with running the business, such as salaries, rent, utilities, and supplies. It does not include investments or interest.
For instance, if a retail store earns $700,000 in sales revenue and has operating expenses totaling $500,000, its OCF would be $200,000 ($700,000 revenue – $500,000 expenses).
Understanding your company’s financial health goes beyond glancing at the bottom line. It involves dissecting key financial metrics, each offering a unique lens through which to view your business’s viability and stability. Let’s explore three pivotal metrics – Operating Cash Flow, Free Cash Flow, and Net Cash Flow – to equip you with the insights needed to steer your business effectively.
A robust OCF can indicate operational efficiency and self-sustainability.
FCF is often spotlighted when evaluating a company’s ability to expand or provide shareholder value.
NCF helps businesses evaluate their liquidity and make informed financial decisions.
Operating cash flow provides a snapshot of the company’s ability to generate revenue from its core operations, which is an indicator of its financial health. This metric is also often used to assess a company’s ability to cover its ongoing expenses and invest in growth opportunities.
Here’s a sum up of insights operating cash flow provides:
Operating cash flow (OCF), net income, and earnings per share (EPS) are three distinct financial metrics that business owners and financial departments should evaluate to understand performance and profitability.
| Metric | Definition | Calculation |
|---|---|---|
| Operating Cash Flow | Measures the cash generated by a company’s day-to-day activities | Net Income + Depreciation and Amortization – Taxes +/- Changes in Working Capital |
| Net Income | Measures a company’s profit or loss after all expenses have been deducted from revenue | Revenue – Expenses |
| Earnings Per Share | Measures the amount of profit earned per outstanding share of a company’s stock | Net Income / Number of Outstanding Shares |
As previously discussed, operating cash flow represents the cash generated from a company’s core business operations, highlighting the efficiency and financial stability of the firm.
For example, a restaurant with a steady OCF generates enough cash to cover its operating expenses, such as wages, rent, and inventory costs.
On the other hand, net income is the total profit or loss after accounting for all revenues, expenses, and taxes.
Suppose a retail store has $1 million in revenue, $700,000 in expenses, and $50,000 in taxes; its net income would be $250,000 ($1 million revenue – $700,000 expenses – $50,000 taxes). This metric evaluates a business’s overall profitability, considering operating and non-operating activities.
Earnings per share (EPS) is calculated by dividing the company’s net income by the number of outstanding shares of its common stock.
For instance, if a tech company has a net income of $2 million and 1 million outstanding shares, its EPS would be $2 ($2 million net income / 1 million shares). EPS is an indicator of a company’s profitability on a per-share basis and is particularly useful for investors when comparing the performance of different companies within the same industry.
Each of these metrics serves a unique purpose, and the preference for one over the others depends on the specific objectives of the business owner or financial department.
For instance, net income and earnings per share might be more appropriate if the goal is to analyze overall profitability or compare performance against industry peers.
Operating cash flow can be calculated using either the direct or indirect formula.
Below is a breakdown of each method:
The direct formula for calculating operating cash flow involves directly analyzing revenue and expenses related to a company’s business activities. The direct formula is:
Operating Cash Flow = Total Revenues – Operating Expenses
To calculate operating cash flow using the direct formula, follow these steps:
Let’s consider a specific example of calculating OCF using the direct formula. Suppose a retail store has the following cash transactions during a financial period:
Revenue:
Expenses:
Using the direct formula, we calculate the operating cash flow as follows:
Total revenue = $300,000 (cash sales) + $200,000 (credit sales) = $500,000
Total expenses = $250,000 (payments to suppliers) + $150,000 (wages and salaries) + $30,000 (rent) + $20,000 (utilities) = $450,000
Operating cash flow = $500,000 (total revenue) – $450,000 (total expenses) = $50,000
The indirect method for calculating operating cash flow involves starting with net income and adjusting for depreciation and changes in working capital. Here’s the formula:
Operating Cash Flow = Net Income + Depreciation and Amortization +/– Changes in Working Capital
To calculate operating cash flow using the indirect formula, follow these steps:
Let’s consider a specific example of calculating OCF using the indirect formula. Suppose a manufacturing company has the following financial data for a given period:
Using the indirect formula, we calculate the operating cash flow as follows:
Adjusted net income = $120,000 (net income) + $30,000 (depreciation) = $150,000
Changes in working capital = $5,000 + $8,000 – $10,000 = $3,000
Operating cash flow = $150,000 (adjusted net income) + $3,000 (changes in working capital) = $153,000
So, when should you use one method over the other?
The direct method is more suitable for businesses that want to closely monitor specific cash transactions related to their core operations, while the indirect method is better for those who need an overview of how net income is converted into operating cash flow.
For instance, let’s say you own a small retail store and are interested in closely monitoring the impact of cash sales, credit sales, and individual operating expenses on your cash flow.
In this case, the direct method would be more suitable as it focuses on specific cash transactions. This approach will allow you to understand the cash collected from customers, payments made to suppliers, wages, and other operating expenses, offering you detailed insights into the revenue generated and used in your daily operations.
On the other hand, if you are the CFO of a large manufacturing company, your primary concern might be to understand the overall cash flow generated from your operations and its relationship with your net income.
In this scenario, the indirect method is preferable as it starts with net income and adjusts for non-cash expenses and changes in working capital. This method provides a big-picture view of how much of your net income is being converted into cash flow from operations without requiring a detailed analysis of individual transactions.
Operating cash flow measures a company’s ability to sustain its operations over time. It can help businesses identify potential cash flow issues and investment opportunities. There are two formulas for calculating operating cash flow: direct and indirect.
