Operating cash flow (OCF) is a calculation that represents the revenue a business generates after operational costs have been deducted, like rent or the cost of actually producing or providing a product/service. In more basic terms, it’s how much cash flow is generated from core business operations (i.e. the sales of a product or service) excluding other sources of revenue, such as investments. 

The Transparency of Operating Cash Flow

OCF is the clearest indicator of whether a business is truly profitable or not. And for that reason, investors are often particularly interested in this number. One of the most telling signs of a successful business is that it makes more money selling a product than it spends to produce it, yet other costs and income can skew these numbers, depending on how the business owner chooses to present them. OCF, however, is very transparent, shining a light on potential problem areas in a business. 

For instance, let’s say there’s a company losing money in one area of their business, like retail activities, but is making money on outside contracts or financing. Looking at overall cash flow, this company might appear to be profitable. But by looking further into the sources of revenue, it becomes clear that the core of this business (i.e. retail activities) isn’t sustainable. Insights like this are just as useful to potential investors as they are to the business owners themselves, as it may show a dire need to pivot a company’s business model. 

Operating Cash Flow Formula

There are two methods for calculating OCF: direct and indirect. While the direct method, which is far simpler to calculate, gives business owners a quick pulse on profitability, the indirect method provides a greater understanding of how various areas of the business are performing. 

GAAP (generally accepted accounting principles) requires the indirect method when calculating annual cash flow statements, which includes operating cash flow. The primary purpose of the statement of cash flows is to provide information regarding accounts receivable and payable resulting from business activities during a certain period of time. 

Direct Method

Total Revenue – Operating Expenses = Operating Cash Flow

As mentioned previously, the direct method for calculating OCF is much simpler, as it only requires subtracting operating expenses from a business’s total revenue. A shortcoming of the direct method is that it doesn’t allow you to discern performance on a more granular level, in that it doesn’t show information about sources of cash or operations. 

Indirect Method

Net Income +/- Changes in Assets & Liabilities + Non-Cash Expenses = Operating Cash Flow

The indirect method is complex but provides a lot more information. The formula for the indirect method adjusts net income to consider changes in non-cash accounts, while depreciation is added into net incomes to adjust for changes in inventory and accounts receivable.

Here’s an example of applying the indirect method of calculating OCF for a hypothetical business: Pam owns a chain of bakeries and is considering opening another storefront, but she wants to be sure her business is profitable enough to support such an investment. When looking at her year-end cash flow statements, Pam can use the following numbers to calculate her OCF:

Net income: $200,000

Depreciation: $20,000

Accounts receivable adjustments: +$75,000

Inventory adjustments: -$15,000

Accounts payable adjustments: -$40,000

Let’s apply these numbers to the OCF indirect method formula:

$200,000 – $75,000 + $15,000 – $40,000 + $20,000  = $120,000

Pam’s bakeries have an operating cash flow of $120,000, meaning she had $120k left over after all bills were paid. Depending on how much it has cost Pam to invest in new storefronts previously, she may or may not decide to use this leftover cash to pursue opening another retail location. 

Systems for Calculating OCF

Producing OCF calculations, not to mention the numerous other financial statements required for a business, can be daunting, especially if you aren’t a bookkeeper. Sure, you could pop all of these numbers into Excel. But as your business grows and becomes more complex, so will your books. That’s why most businesses rely on bookkeeping software to track expenses, show current cash flow, and produce cash flow forecasting. 

When a business owner has a firm grasp on their operating cash flow, strategic business decisions can be made with confidence. Here at Scalefactor, we are here to help you avoid any accounting surprises, and provide the Business Insights you need to grow.

Jennifer Rampolla &Jennifer Rampolla
AX Manager