How to calculate OCF (operating cash flow)

What is Operating Cash Flow?

Operating cash flow is a financial metric that tells you how much cash your company’s business operations and core businesses generate. 

For example, a civil engineering firm derives operating cash flow by calculating the revenue generated by the engineering consulting and construction service costs they charge their customers.

Operating cash flow does not include other funding sources, such as investments and loans.

Operating cash flow can be impacted positively and negatively by certain events that may (raising prices) or may not (increase in material costs) be in a company’s control. 

However, companies can take steps to increase positive cash flow, which we will get into later in this post.

How to Calculate Operating Cash Flow

For people without finance experience or who don’t spend time in Excel spreadsheets all day, calculating operating cash flow may seem difficult, but it can easily be managed by following best practices. 

Calculating OCF can be done using the direct or indirect method.

While each method differs slightly, both require understanding your income statement and balance sheet. 

In both instances, leveraging current assets and current liabilities will build your operating cash flow.

Option 1: The Direct Cash Flow Method

The direct method calculates OCF by adjusting the company's total cash receipts based on changes in operating accounts. 

It involves garnering cash payments from customers and subtracting cash outflows made to suppliers and employees as part of operating expenses. Non-cash items are ignored.

Meticulous tracking of all cash inflows during the accounting period is essential when using this method.

Here’s a template of the OCF formula using the direct method:

OCF = Cash received from customers – Cash paid to suppliers and employees - Cash paid for other expenses

Option 2: The Indirect Cash Flow Method

Favored by some CFOs and financial analysts, the indirect method starts with net income and adjusts for changes in operating activities.

These adjustments account for non-cash items (e.g., non-cash expenses), prominently including depreciation and amortization. 

Changes in operating liabilities, current assets, and accruals are also factored in for this method.

Here is the operating cash flow formula you would use for the indirect method:

OCF = Net Income + Depreciation (D&A) + Net Working Capital

Direct cash flow vs. indirect cash flow method

If both methods yield the same OCF correctly, how do you decide which to use? The answer depends on a few factors, including ease of data collection, industry, level of granularity sought, time available, and other needs.

Here are some starting points to help you evaluate the right method for your business:

• The indirect method is generally easier to prepare because it leverages data that is readily accessible in your P&L statement and balance sheet. 
• It also provides more points of comparison and reconciliation across your financials because it includes net income, which you can compare to cash flow to understand how your business collects cash.
• However, the direct method may offer more simplicity because it is based on cash transactions received or paid out. Compiling via the direct method may require tailored transaction-level classification.
• While both are considered GAAP, many public companies compile their statement of cash flows. Accounting standards encourage firms to use the direct method.

Net Cash Flow vs. Operating Cash Flow

OCF helps businesses understand the amount of cash that their main business activities generate, but a different data point, net cash flow (NCF), is used when finance professionals want a more comprehensive view of a company’s activity.

Beyond operating income derived from producing and delivering goods and services, NCF also accounts for total cash inflows and outflows that result from investing and financing during a given period. NCF is calculated in the Statement of Cash Flows financial statement.

Here is a formula you can use to calculate NCF:

Net Cash Flow = Cash flow from operating activities + Cash flow from investing activities + Cash flow from financing activities

Why would someone want to measure NCF? 

One example is when you are acquiring or lending another company money and want to understand all aspects of the entity’s financial health, including its investing and financing activities.

What is Free Cash Flow (FCF)?

Another term we will mention here is Free Cash Flow (FCF), another measure that can offer you more managerial control. FCF calculates the leftover cash after the company has funded all operating expenses and capital expenditures (CapEx).

Therefore, it represents a company's capacity to generate cash after laying out the money required to maintain or expand its asset base.

FCF = OCF – CapEx

Identifying and understanding the top-line financial metrics, cash and non-cash, that best fit your business will improve your decision-making.

Four best practices for managing cash flow

Effective cash flow management is vital for a company's financial health, regardless of its size—whether small or large businesses.

Here are a few recommended practices:

1. Monitor your cash flow regularly

Harness the power of financial statements, including your balance sheet, income statement, and especially your cash flow statement.

Regularly reviewing these reports can give you a clear picture of where your cash inflows and outflows are from.

2. Maintain and optimize your cash reserves

While maintaining cash reserves is essential, optimizing them for yield and safety is equally crucial.

A good strategy includes utilizing cash management tools to separate operational and non-operational funds. 

For instance, Rho's Prime Treasury and Treasury Accounts offer this advantage, helping businesses like Mento diversify their funds and generate yield.

Additionally, for businesses with more significant liquid assets, Rho Prime Treasury allows the investment in short-term government securities held directly in your company's name, offering higher yield potential with the comfort of diversification.

Companies like Mento have successfully implemented this, diversifying their funds and ensuring financial stability during unexpected events, such as the 2023 Silicon Valley Bank crisis.

3. Get your forecasting right

Being able to predict your cash inflows and cash outflows is an integral part of cash flow forecasting. 

This practice can help manage operating expenses, plan for capital expenditures (CapEx), and make strategic decisions.

4. Speed up receivables

If feasible, implement strategies to collect your accounts receivable more quickly.

Stretch payables

An effective strategy for better cash flow management is to negotiate longer payment terms with your suppliers, thus keeping cash within your business for longer.

One way to accomplish this is by automating the accounts payable function, allowing you better visibility over payment schedules.

With the use of automation, you can time your payments most beneficially to meet your cash flow needs. 

Tools like Rho AP provide an excellent solution for automating and streamlining this process, further enhancing your business' cash flow management.

Forecast your cash flow

Cash flow forecasting can help you anticipate periods of negative cash flow and plan appropriately.

Software solutions for operating cash flow management

With the rising complexity of a business's financial ecosystem, a range of cash management tools have emerged, including operating cash flow calculators.

Such devices can streamline tracking and strategize over economic activities, including receipts from customers, invoice payments, calculating depreciation, expense management, income taxes, capital expenditures, and changes in working capital.

Moreover, these tools can help you adhere to the guidelines established by the Generally Accepted Accounting Principles (GAAP)—a boon for firms following the accrual method of accounting. 

It's equally valid for ventures operating on a cash basis.

Some of these tools include:

• Accounting software: Tools like QuickBooks Online, NetSuite, Sage Intacct, and Microsoft Dynamics 365 Business Central offer specialized accounting features to help you manage cash flow more effectively.
• Financial dashboards: These platforms provide a visual snapshot of your business's financial data, highlighting vital metrics such as OCF, net income, and more.
• Spend and cash management platforms: Platforms like Rho can help you manage all of your spend and cash centrally across key processes like accounts payable, corporate card spending, banking, and treasury.

Wrap-up: Getting cash flow management right

Effective cash flow management is paramount whether you're a small business owner charting a new course, navigating varying growth strategies, or an established enterprise wrestling with intricate operations.

A comprehensive understanding and efficient management of your operating cash flow is critical in assessing your company's ability to sustain its financial health and sustainability and drive growth within a given period.

Furthermore, tools and best practices such as cash flow calculators, regular monitoring of financial statements, and maintaining healthy cash reserves will ensure your firm's survival and propel it toward long-term financial stability and success.

Whether your business dealings are executed on a cash basis, or your financial records align with GAAP or accrual accounting, your operating cash flow is a crucial determinant of your company's financial robustness, irrespective of your total revenue or stock-based compensation practices.

Remember, as a business owner, your primary aim is to generate cash from your core business operations that extend beyond merely covering operating expenses and ensure your company's successful growth over the long haul.

Therefore, a relatable understanding and accurate operating cash flow calculation become paramount in your entrepreneurial arsenal.

Rho helps drive business growth by providing access to corporate cards, banking, AP, and more, all on a single fee-free platform. To learn more about how Rho can boost your business get in touch here.