If you want to measure how much your business is making from its day-to-day operations, you'll need to know how to calculate your operating cash flow.
Profits vary between each business, but learning more about your own cash flow can help you determine whether or not your business is making enough to maintain and grow or if it requires extra funding to stay afloat and succeed.
In this article, we'll walk you through the ins and outs of operating cash flow and how you can calculate it yourself.
What Is Operating Cash Flow?
In simple terms, your operating cash flow is the amount your business generates from its operations.
Operating cash flow does not account for any investment or financing activities, and it focuses exclusively on how much you're making from your regular, day-to-day business.
The amount of cash you're generating is used to understand how viable your business operations are.
For a business to be viable, it needs a positive cash flow to maintain itself and grow, and a positive operating cash flow is a good indicator of the financial health of your business.
Operating cash flow is usually the preferred way to establish viability. Some businesses use net income - however, net income can be altered by different revenue streams and expenses, making it a less reliable indicator than operating cash flow.
There are two ways to represent operating cash flow - the direct method and the indirect method. Let's take a closer look at these methods below.
With this method, you'll individually list any cash from your customers and anything you've paid out for, such as staff and supplies.
All non-cash transactions are ignored, and you'll generate a final closing bank statement, which you'll also get from the indirect method (more on this later).
Using the direct method has its own unique advantages. For example, you'll get a better idea of your inflow and outflow.
This can help you identify any problem areas and opportunities that may arise in the future, which is great for both short and long-term planning.
Understanding the past operations of your business will show you how to manage it in the future.
However, the direct method can often be pretty time-consuming. With this method, you'll have to look far beyond your balance sheet and income statement accounts to get the right numbers.
With the indirect method, you'll start off by analyzing the net income of your business.
You'll then make a number of adjustments, such as any changes to inventory, payables, amortization, and depreciation, to get the cash flow from your regular business activities.
When you're done implementing the appropriate adjustments, you'll finish off with a final bank position.
With the indirect method, it's easier to see how your net profit differs from your final bank position.
However, the indirect method doesn't offer as much insight into your cash transactions and a breakdown of them, which could mean you're missing out on finer details and insights.
How To Calculate Operating Cash Flow
Ready to start calculating your operating cash flow? You'll first need to decide whether you want to use the direct method or the indirect method. We'll list the appropriate formulas for each method below.
The Direct Method Formula
If you're using the direct method, you'll simply need to take away your business expenses from your total revenue with this formula:
Total Revenue - Business Expenses = Operating Cash Flow
This is a simple formula to do. If you've never calculated operating cash flow before, it may be a good place to start.
However, it doesn't offer your investors much insight into your cash sources and business operations, which is why the indirect method is often the most popular.
The Indirect Method Formula
If the indirect method looks like your preferred route, you'll need to perform a slightly lengthier formula.
Total Income +/- Asset and Liability Changes + Non-Cash Expenses
Although this formula is more complex, as you can see, it provides a more reliable insight into the financial health of your business by assessing more factors than the direct method.
If you're using the indirect method, there are a few things you'll need to remember:
Think of it this way - if your inventory reduces during the year, it's because you sold it and received cash. So, you'll need to add any decrease to your inventory back into your net income to take note of the profit.
Choosing The Right Formula
Choosing the appropriate formula can be confusing. Ultimately, whatever formula you use is going to give you the same number, so how do you know which one works best?
The most important factors to consider are who you're reporting to and what data you have available. Whether you're presenting to a bank or a shareholder, the audience will determine which method is best.
Although each formula delivers the same end result, the indirect method provides a more in-depth breakdown of your business operations, which may be more valuable to a shareholder rather than a bank.
You'll also need to consider other factors, such as:
Calculating your operating cash flow isn't as long and complex as you might think. You'll need to choose between two methods, each with its own advantages and disadvantages.
The method you choose will depend on who you're presenting to, what resources you have, and how simple you need to process to be. If you're unsure which formula to choose, consult a qualified accountant for more information.
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