There are several parameters that tell about the performance and the overall health of a business. You can look at a business’s total sales, profit, or working capital, but the most simple yet effective parameter is operating cash flow.
It is an important indicator of the performance of businesses. Hence, investors often ask for the operating cash flow before lending out the funds. So, let’s take a look at what it really is and how you can calculate it using an operating cash flow calculator.
What Is Operating Cash Flow?
Operating cash flow is the amount generated by a business’s operations. It tells whether the business needs enough revenue or external funding to maintain its operations. Most investors look at the operating cash flow because it tells the present performance of the business.
Most other parameters provide a picture that considers the previous months’ performance. Hence, they might not be as useful to gauge the exact financial standing of a business in the present.
However, if the business’s cash flow is down, it does not necessarily indicate a bad performance. Sometimes businesses have invested a large amount of capital in assets that are yet to mature and generate revenue.
Hence, while the operating cash flow is important, it must not be looked at in isolation. Other documents, such as the balance sheets and balance statements, should also be considered.
How To Calculate Operating Cash Flow?
There are two ways to calculate and present operating cash flow: the direct and indirect methods. The formula to calculate operating cash flow with both methods is different and has different applications. Let’s take a look at them:
Direct Method
Direct Method is the simple way to calculate operating cash flow. It only takes the cash transactions into account to calculate the operating cash flow. The following items are included in the calculation of operating cash flow with the direct method.
- Income tax and Interest
- Revenue collected from customers
- Expenses like vendor invoices
- Salaries of the employees
- Rents of the space
The direct method is simple and can be used by businesses that do not have non-cash accounts.
Indirect Method
Large-scale businesses with non-cash accounts prefer the indirect method of calculating operating cash flow. The formula to calculate it is as follows;
Operating Cash Flow = Net Income + Amortization + Depreciation + Change in working capital + Net of other cash flows + Income tax Payable.
Large businesses use the indirect method because it adjusts the net income to the cash basis, even from non-cash accounts. It uses parameters such as depreciation, accounts payable, and accounts receivable to adjust the net income to a cash basis.
Furthermore, the indirect method also uses amortization because most companies report their net incomes based on accrual accounting.
The indirect method also adjusts the changes in working capital to the net income. It makes the calculation more precise because it only considers the amount that has been actually received. For example, an increase in accounts receivable indicates that the business has generated some revenue.
But that does not necessarily mean that capital has been deposited in the account. It is quite common in businesses that use accrual accounting. Hence, such an increase in account receivables must be excluded from net income for accurate operating cash flow estimation.
Account payables also have a similar case. Just because an increase in accounts payable is recorded does not mean that the business has lesser capital at hand. Hence, the addition in account payables must also be subtracted to find the actual cash impact.
We know calculating operating cash via indirect method can be difficult, but it is accurate and precise. And fortunately, the online cash flow calculator makes things easier. You have to provide it with parameters like depreciation, income tax payable, and net income, among others, and it will provide you with the exact operating cash flow figure.
How To Interpret Cash Flow From Operating Activities?
The operating activities of a business are listed on the cash flow statement. A cash flow statement generally has three sections: financing, investing and operating. You can interpret the cash flow by these activities as well.
Operating activities generate revenue for the businesses. It includes the capital businesses receive by selling their services, products, or both. Furthermore, it also takes the capital required to deliver the product and services. If the net income from operating activities is positive, it means the core elements of a business are thriving and generating profit.
Investing activities include the capital that goes out from businesses to the investments and the capital that is generated from an asset. For example, if a business invests $100 million in an asset and generates $150 profit, the net capital from investing activities would be $50 million. It means that investments in businesses are not dead and are actually generating revenue.
Lastly, the financing activities consider debt payment and debt acquisition. In contrast to other activities, financing activities should be negative. Net negative financing activities mean that the business has made more repayments than the amount it has borrowed. A positive sum of financing activities indicates that the business had to acquire funding to sustain its operations.
Looking at these activities on the cash flow statement lets you know the performance of different aspects of the business. You can use it to make better and more informed financial decisions.
FAQs
What Is A Good Operating Cash Flow?
The operating cash flow of a business is gauged by a ratio of standing liabilities to available cash at any point in time. A ratio below 1 indicates problems in cash flow, and anything above 1 is considered sufficient to take care of short-term obligations.
How To Calculate Operating Cash Flow?
You can calculate operating cash flow by subtracting the sum of taxes and changes in working capital from the sum of operating income and total depreciation.
How Long Until Operating Cash Flow Doubles?
There is no fixed time in which the operating cash flow of the business doubles. It depends on the performance of the businesses and the revenue it generates from the operations.
For example, Businesses that can double their revenue in a month would require a month to double their operating cash flow.
What To Do If A Company I Invested In Reported Negative Operating Cash Flow?
Negative operating cash flow means that the company does not have enough capital to meet short-term financial obligations. However, it is not always an indicator of bad performance.
Sometimes companies report negative operating cash flow because they invest a large portion of capital into an asset. Hence, other factors must be considered when deciding on an investment.
What Is The Operating Cash Flow Formula?
The formula to calculate operating cash flow is Depreciation + Operating Income – Changes in Working Capital + Taxes.
Is Operating Cash Flow The Same As Net Income?
Operating cash flow and net income are not the same. Net income is the capital left after clearing all the dues, including personnel salaries, inventory costs, and taxes.
On the other hand, operating cash flow is the total revenue generated by a business’ operations. Taxes and other expenses are not excluded from the operating cash flow.
How To Improve Cash Flow From Operations?
There are several ways to improve cash flow from operations which include but are not limited to cutting unnecessary expenditures, shortening payment deadlines, negotiating better payment terms, and forecasting expenses.
Why Is Operating Cash Flow Important For Investors?
Operating cash flow is an important indicator of a business’s health and performance. It measures a business’s capabilities to cover its liability at any given time. Investors can judge the potential of a business by looking at the operating cash flow.
It is a vital but not the only important factor. Several reasons decrease cash flow, but they do not necessarily mean the business is struggling.
How To Find Operating Cash Flow?
Operating cash flow can be found by using the formula Depreciation + Operating Income – Changes in Working Capital + Taxes. Furthermore, one does not need to calculate the working capital by oneself. There are online calculators that offer quick solutions.
How To Calculate Operating Cash Flow From The Income Statements?
You can calculate the operating cash flow by separating expenses and revenue from income statements. Subtract the expenses, including the taxes, to get yourself an operating cash flow amount.
Conclusion
Operating cash flow is one of the key indicators to gauge the performance of a business. It lets the investor know about a business’s capabilities to pay off liabilities. Furthermore, the operating cash also gauges the business’s potential, making it very important for investors.
Hence, if you are looking for funding from an investor or simply want to judge the performance of a business, operating cash flow is a simple yet effective parameter.
