If there's one universal tenet that every business owner intrinsically understands, it's that you can't run out of capital. While this is much easier said than done, even successful enterprises face bankruptcy, and there are many reasons why this can occur. However, one of the primary culprits for business hardship is cash flow management — as many business owners fail to understand the basic principles of operating cash flow (OCF). Having a firm grasp on both profit and profitability is a key to business success, and one of the major contributors to this is OCF.
- Operating cash flow is what a business generates from its operational activities. It's a tell-tale sign that your business is creating enough profit to sustain at a minimum level, but it can also indicate possible future growth.
Now, this is in direct comparison to what's known as net income, another indicator of company health. However, net income and OCF are not the same measurements — and knowing the difference can be a significant advantage when taking control of business finances.
- Net income refers to the amount that remains after subtracting your total expenses from your revenue. Think of net income as a big-picture indicator of how much your business has made over a set period of time. The big difference here is that net income won't dive into the details of what your day-to-day operations are doing for your overall business health.
Operating cash flow can be a sound indicator of company health, but that's not its only purpose. OCF can also showcase whether or not a company can benefit from various forms of business financing or loans.
How can you manage operating cash flow to safeguard your company's future and stay prepared for potential hardship? Well, we're here to break down the formula and give you the tools necessary to handle your OCF with ease.
Calculating Operating Cash Flow (The Easy Way)
Calculating your OCF requires a simple yet extremely helpful equation.
Operating Cash Flow = Net Income = Non-Cash Expenses
You'll also need to factor in depreciation or amortization as well, but we'll get to that in just a moment. For now, let's make sure we have a clear-cut understanding of the components of the operating cash flow equation.
We covered some of the basics already in this article, but here's a refresher:
- Net income refers to the amount that remains after all of your expenses have been subtracted from the business's total revenue.
- Non-Cash Expenses refer to all of your business's non-cash entries on an income statement. These aren't movements of capital but rather accounting entries such as depreciation and amortization.
- Depreciation refers to a reduction in a business asset's value — which will need to be addressed by adding this expense back into the net income in order to get an accurate OCF value. Some examples of depreciating assets are equipment, vehicles, land, buildings, and machinery. These are especially important when factoring in equipment loans or financing.
- Amortization refers to intangible assets and the method used to spread these costs over their shelf life. These are not necessarily physical assets but rather those such as patents, organizational costs, franchise agreements, copyrights, or trademarks.
How Working Capital Fits Into the Equation
Working capital is what fuels your company, and having cash flow on-hand to manage your operating expenses is crucial. Working capital is the difference between your current assets and current liabilities — and it's a good indicator of short-term financial well-being.
Examples of Current Assets May Include
- Inventory
- Property
- Cash-on-hand
Examples of Current Liabilities May Include
- Wages
- Rent
- Taxes
- Utilities
So, how does working capital factor into your OCF? Well, you'll need to subtract out any increases in assets, and you'll need to add in any decrease in assets. Let's look at this in practice.
If you're able to make some negotiations with a vendor to obtain a longer repayment term — your accounts payable balance will subsequently go up, boosting your cash flow.
Now that we've covered all of the basics and intricacies of OCF — let's try out an example to see how your business can take advantage of these formulas and equations to better understand how day-to-day expenditures affect your company.
A Helpful OCF Example
So, you're ready to see how an OCF calculation looks on paper. Tim owns an autobody shop and is looking to get a better understanding of his day-to-day spending. Here's what his current situation looks like:
- He has roughly $100,000 in net profit.
- He's looking at around $50,000 in uncollected debt from detail work and repairs.
- He owes roughly $10,000 to manufacturers for replacement parts.
- Tim also has a company vehicle that is a few years old and wants to continue driving the car for roughly 5 more years. It has a depreciating expense of around $3,000 per year.
Now, let's take a closer look at our friend Tim's operating cash flow statements. His net earnings are $100,000 — while his non-cash expenses are $3,000.
He also has some changes in his working capital, as he's owed $50,000 in uncollected debt from customers (Accounts Receivable), and he owes $10,000 to manufacturers for parts. Now, let's plug all of this information into our OCF formula and see how Tim is doing.
$100,000 (net income) + $3,000 (depreciation) = $103,000
Now we have to factor in changes to working capital.
$103,000 (OCF) + $10,000 (Accounts Payable) - $50,000 (Accounts Recievable) = $63,000
Tim has $63,000 in operating cash flow at this time. This number shows that Tim can run his operation and still has an additional $63,000 to utilize for growth or other company initiatives.
Now, there are plenty of factors that could influence just how accurate this amount is — such as factoring in investment costs or financing. It's another simple step that involves subtracting loan payments or investment in machinery or equipment. So, if Tim took out a $10,000 loan and invested in a new scissor lift for $2,000 — he would need to subtract an additional $12,000 from his OCF, leaving him with $51,000.
Using an OCF Formula For Your Business
Calculating your operating cash flow can illustrate just how solvent your company is at any given time. Some negative cash flow here and there doesn't always spell disaster, but you can certainly get a grip on trends that may indicate the direction of your business.
You can use this formula to discover any glaring issues that can be solved rather quickly, such as purchasing less inventory or extending repayment terms. Calculating OCF may also indicate that it's time to raise prices on your products or services or evaluate cash flow loans to assist in the short term.
Many of the best accounting software for small businesses have tools and programs to calculate OCF with ease. Get started today and discover what your cash flow situation looks like.
