operating cash flow

Small Business Guide to Operating Cash Flow | SMB Compass

Ezra Cabrera | January 18, 2021


    Understanding your company’s operating cash flow is the key to improving long-term financial health. According to Business Insider82% of businesses fail because of poor cash flow management or a poor understanding of the importance of cash flow.

    While this statistic may seem disheartening to aspiring entrepreneurs, it also shows the significance of having control over your finances. The more you understand your cash flow, the better you will be at managing your money and your business.

    In this article, we’ll dive deeper into operating cash flow and break down how to calculate it.

    What Is Operating Cash Flow and Why Is It Important?

    The number one rule when running a business is to never run out of money. Small business owners spend most of their time working on their profit and loss statements, but if you truly want to assess your company’s financial health, you’ll need to pay attention to your operating cash flow statement as well.

    Operating cash flow (OCF) is the greatest indicator of whether your business is making money or not. It’s a calculation of how much revenue your business generates after subtracting operational costs (or the total expenses incurred after producing products or providing services). In other words, it’s the total cash flow generated from the basic business operations – the selling of your products or services – without including other sources of revenue like investments and interest.

    Here are some of the reasons why it’s essential to calculate your operating cash flow:

    • Easily manage your expenses. By calculating your OFC, you can easily track and manage your expenses to accurately calculate sales and make forecasts.
    • Get a clearer picture of your future cash flow. Creating cash flow forecasts based on previous sales and expenses helps you properly allocate your working capital and identify potential cash flow dips.
    • Make your business more attractive to investors and lenders. Investors and lending institutions would want to know more about your company’s financial health before investing in your business. Your operating cash flow gives them insight into your business’ market demand, business cycles, management competence, and any significant changes in your operations.

    The Difference Between Net Income and Operating Cash Flow

    Small business owners often assume that operating cash flow is the same as net income or net profit. While both terms are related, they aren’t interchangeable, and there’s a difference between the two.

    Net Income

    Net income gives you a broader number, and it’s calculated by subtracting your expenses from your revenue. Simply put, net income lets you know the amount of money you made during a specified period, but it doesn’t tell you when the inflows and outflows of cash were made. That’s why they’re not a clear indicator of your business’ overall financial health.

    Here’s an example: Companies ABC and XYZ report the same net income. Company XYZ regularly experienced cash shortfalls and didn’t have enough cash to pay day-to-day expenses, while Company ABC was doing just fine.

    So, what went wrong? Even though both companies have the same net income, Company XYZ is slow to collect invoices compared to Company ABC, which is why XYZ has lower operating cash flows.

    This example proves that even if your small business has a stable financial trajectory, you’ll find yourself in a difficult situation if you struggle with increasing your income relative to expenses.

    Operating Cash Flow

    A clear sign of having a successful business is that you’re making more money selling goods while spending less money making them. However, other expenses and income can affect these numbers. Your operating cash flow shines a light on potential problems your business is facing as it’s already adjusted for receivables, liabilities, and depreciation.

    Here’s an example: A retail company is not making enough money by selling their goods, but financing and outside contracts make up for that loss. If you look at the overall cash flow, the company might appear profitable. But if you assess the primary business operations (selling products), it won’t sustain the business in the long run.

    These insights are valuable to business owners as it shows the need to pivot the business model to improve profitability.

    Operating Cash Flow Formula

    There are two ways to calculate the OCF: direct and indirect methods.

    The direct method is simpler to calculate, and it gives you a quick idea of your business’ profitability. The indirect method is an in-depth assessment of how your business performs in various areas.

    How you calculate your operating cash flow depends on you, but the Generally Accepted Accounting Principles (GAAP) require the indirect method when calculating cash flow statements, which includes OFC.

    Direct Method

    Total Revenue – Operating Expenses = Operating Cash Flow

    To get the OFC using the direct method, you only need to subtract the operating expenses from your total revenue. The downside of using the direct method is that you won’t get to evaluate your performance on a granular level since it doesn’t show a lot of information on sources of cash and operations.

    Indirect Method

    Operating Cash Flow = Net Income + Non-cash Expenses +/- Changes in Working Capital
    Here’s a breakdown of each component of the formula to further understand how the indirect method works.

    Net Income

    As mentioned earlier, net income is the amount of money you have after deducting the expenses from the total revenue.

    Non-Cash Expenses

    Non-cash expenses are financial entries included in your income statement but don’t directly affect cash flow. Amortization and depreciation are the most common examples of non-cash expenses. When your equipment depreciates, you don’t need to pay for “depreciation expenses.” Instead, the depreciation is reflected in your books as the reduction in assets. You’ll need to add non-cash expenses to your net income to get the OFC.

    Changes in Working Capital

    Working capital is the difference between your business’ current assets (inventory, accounts receivable, etc.) and current liabilities (accounts payable). You need to subtract any increases in assets while decreases should be added back in. For liabilities, you’ll need to add the increases and subtract the decreases.

    For instance, negotiating longer repayment terms with suppliers and vendors increases your accounts payable balance, which is good for your cash flow.

    Example of an Operating Cash Flow

    Now that you know how to calculate the OFC, here’s a basic example of an operating cash flow statement.

    Stuart Miller owns a retail shop called Miller’s Goods, and this is what his finances look like:

    • Stuart has $130,000 in net profit.
    • He owes $20,000 to his suppliers.
    • He has $70,000 debts to collect from his customers.
    • He bought a delivery van that he plans to use for five years, and it has a $7,000 annual depreciation expense.

    Miller’s Goods operating cash flow statement:

    Operating Cash Flow
    Net Earnings $130,000
    Plus: Depreciation and Amortization
    Changes in Working Capital
    Less: Accounts Receivable ($70,000)
    Plus: Accounts Payable $20,000
    Operating Cash Flow for Miller’s Goods: $87,000

    Stuart was able to generate $87,000 of cash flow from his operations alone. This means his business activities are successful and he could pay for daily expenses with more than enough to invest in growth and expansion.

    Keep in mind that OFC is only a component of your company’s overall cash flow statement. You’ll need to consider the costs associated with investments and financing activities to truly know your available cash flow.

    For instance, Stuart recently invested $15,000 on a piece of equipment and paid $30,000 against several small

    business financing programs. Here’s what his cash flow statement should look at:

    Investing Cash Flow
    Less: Equipment Investment ($15,000)
    Investment Cash Flow for Miller’s Good: ($15,000)
    Financing Cash Flow
    Less: Loan Payment ($15,000)
    Cash Flow from Financing: ($30,000)

    ENDING CASH: $42,000

    What Operating Cash Flow Statements Tell You

    The goal of every business is to make a profit, which means your OFC should remain positive. A few months of negative cash flow won’t hurt the bank, especially for seasonal businesses. But you’d want your OFC to be on the positive side most of the time for your business to remain solvent.

    By reviewing your cash flow statement regularly, you can quickly remedy cash flow issues that may arise. You’ll know when to raise prices, apply for business loans, negotiate terms with suppliers, or buy less inventory.

    Staying on top of your finances is one of the most important actions you can take for your business. Calculating your OFC and making your cash flow statements can be overwhelming, but there are many resources available at your disposal.

    Most accounting software platforms, like FloatQuickBooks, and PlanGuru have built-in features to help you create a cash flow statement for your business. You can find articles, calculators, and templates at the U.S. Small Business Administration and SCORE websites for more information.


    If you have a firm grasp of your operating cash flow, you’ll be able to make strategic business decisions that propel your business forward. Outside investments can keep your business afloat during slower seasons, but your operating cash flow allows you to determine your business’ true profitability.

    About the Author

    Ezra Neiel Cabrera has a bachelor’s degree in Business Administration with a major in Entrepreneurial Marketing. Over the last 3 years, she has been writing business-centric articles to help small business owners grow and expand. Ezra mainly writes for SMB Compass, but you can find some of her work in All Business, Small Biz Daily, LaunchHouse, Marketing2Business, and Clutch, among others. When she’s not writing, you’ll find her in bed eating cookies and binge-watching Netflix.