woman doing accounting

After months of blood, sweat, and tears, your small business is finally taking off; the phones are ringing, website visitors are placing orders, and leads are finally converting into clients. That’s great news! But keep in mind that as your business continues to grow, it becomes more important than ever to have a clear understanding of your operating cash flow.

Operating cash flow (OCF) is essential to the survival and growth of any business, from local hair salons to Fortune 500 companies.

After all, cash is what pays the bills and ensures your business runs smoothly – whether it’s spent on paying suppliers, funding employee payroll, or other business expenses like rent, taxes, or operations expansions.

What is Operating Cash Flow?

Operating cash flow is a financial metric that measures cash flow (the net amount of cash and cash equivalents transferred in or out of a business) generated by normal business operations, such as providing a service like a haircut or selling a product like a lawnmower.

Owners and investors pay special attention to this number as it indicates whether a business actually generates a positive cash flow, which can then be re-invested to grow the business or taken out as profit.

On the other hand, a business with negative cash flow would require constant funding to stay afloat – either through additional equity provided by the owners or by borrowing money from creditors through loans or lines of credit.

How to Calculate Operating Cash Flow

There are two methods to calculate operating cash flow, each with its pros and cons. We’ll explain both in the next section so you can determine which is right for you. 

The Direct Method for Calculating Operating Cash Flow

The direct method is exactly what it sounds like – a direct way of calculating operating cash flow by deducting the total amount of cash expenses from the total amount of cash receipts:

OCF = Total Cash Receipts – Total Cash Expenses

In other words, it’s the net cash flow that your business generates from operations after paying your suppliers, employees, and other cash expenses.

Let’s consider a quick example: John is a local handyman with the following financials from last year:

  • Cash Receipts: $10,000
  • Cash Expenses: $3,500
    • Supplies: $2,000
    • Vehicle Expenses: $1,500

Based on these numbers, we can calculate operating cash flow as follows:

OCF = Cash Receipts ($10,000) – Cash Expenses ($3,500) = $6,500

Now, while the direct method is simple and straightforward, it only works if your business is already using a cash-based accounting system where you’re keeping track of cash-based receipts.

This method might work well for a local handyman who only accepts cash payments and also covers most of his expenses in cash.

But the majority of businesses use an accrual-based accounting system, where revenue is recognized when earned and expenses are recognized when incurred, rather than when cash is received or paid out.  This makes it difficult to calculate the businesses’ operating cash flow using the direct method, which is why the indirect method is preferred in most situations.

The Indirect Method for Calculating Operating Cash Flow

The indirect method is more frequently used to calculate operating cash flow because this method of calculation is straightforward for businesses that use accrual-based accounting.

The formula for the indirect method is as follows:

OCF = Net Income + Non-Cash Expenses + Change in Working Capital

Using the indirect method, we start with net income and add back non-cash expenses like depreciation and then adjust for changes in working capital.

Working capital is defined as:

Working Capital = Current Assets – Current Liabilities

A current asset is cash or anything that is expected to be converted to cash within a year. Current liabilities, on the other hand, are financial obligations that are due within a year.

Let’s consider another example: Jane runs a local pastry shop with the following financials from last year:

  • Net Income: $15,000
  • Depreciation: $2,500
  • Change in Working Capital: ($1,000)
    • Change in Accounts Payable: ($2,000)
    • Change in Accounts Receivable: $1,000
    • Change in Inventory: $0

Based on these numbers, we can calculate OCF using the indirect method as follows:

OCF = $15,000 + $2,500 – $1,000 = $16,500

In this example, Jane had a net income of $15,000 last year but $2,500 was a non-cash expense for the depreciation of her baking equipment, so we added it back.

In addition, the change in working capital was ($1,000) which means it was a use of cash, so we subtracted that amount.

More specifically, the change in accounts payable was ($2,000) which means Jane had to use cash to pay her suppliers faster than before, perhaps due to a reduction in supplier credit terms.

Meanwhile, the change in accounts receivable was $1,000, as Jane was able to collect cash from customers more quickly, perhaps by managing her larger accounts better or by offering a discount on cash sales.

As you can see from the example above, using the indirect method to calculate OCF has the added advantage of providing more insight into your business’s cash flow from operations. This enables you to take actions that can further improve your cash flow, like negotiating with suppliers for longer credit terms, incentivizing customers to pay faster, and reducing excess inventory stock.

Why is Operating Cash Flow Important?

As the saying goes, “cash is king”, since it represents the lifeblood of any business. 

But cash can be generated from different sources – operating, investing, and financing – each with its pros and cons.

Cash flow from investing refers to cash created or used by investment activities, such as the purchase or sale of property & equipment or the acquisition of another business.

Cash flow from financing refers to cash provided through financing activities, which could be taking out a bank loan or paying the business owners a dividend.

While investing and financing activities can provide a business with short-term sources of cash by selling assets or borrowing from creditors, neither option is sustainable in the long run. 

That’s why it’s essential for your business to generate a positive cash flow from its operations, as doing so is the primary long-term means by which your business can have the capital available for future growth. 

In addition, operating cash flow is more predictable than investing or financing, which are often one-time events, and it allows business owners to plan ahead and budget their expenses more accurately.

Manage Your Cash Flow Better with Gravity Capital

At Gravity Payments, we know how difficult it is for small business owners to manage their fluctuating cash flow needs.

That’s why we launched Gravity Capital; to provide quick and easy funding solutions for our merchants with flexible repayment options.

Apply today to see how much your business qualifies for; once approved you’ll gain access to your funds quickly and conveniently with next-day funding. Plus, we offer the option to pay back your loans in a way that works for you, through adjustable repayment timelines that scale with your business.

Categories: Finance, Small Business Advice