How to calculate operating cash flow?

Operating cash flow is an important financial metric for businesses because it provides insight into the cash generated or used by the company’s core operations. In other words, it is like the lifeblood of a business as it’s the money that flows in and out of the company’s core operations. Generally, a positive operating cash flow means the business is doing well and has enough cash to cover its expenses and keep the lights on. A happy dance moment for any business owner! On the other hand, a negative operating cash flow might call for urgent action. Cash flow forecasting, that is explained in at the end of the article, can be especially useful when trying to understand why your operating cash flow is negative.

This is the formula for calculating operating cash flow for a specific chosen time period:

Operating Cash Flow = Net Income + Non-Cash Expenses – Changes in Working Capital

To start calculating an operating cash flow let’s have a look at what each of these terms means:

Net Income: This is the profit or loss that a company has earned during a particular period, as reported on the income statement. It includes all revenue and expenses, including taxes. You can look at it as the final boss of the income statement, the grand total of all the money the business made and spent during a specific period of time.

Non-Cash Expenses: These are expenses that do not involve cash transactions, such as depreciation and amortization. They are added back to net income because they do not represent a cash outflow. Depreciation means that if a business buys a fancy new computer for €2,000, they might depreciate it over five years, meaning they deduct €400 from their income each year to reflect the computer’s decreasing value. Whereaase amortization means that if a business pays for something, for example a patent that costs €50,000, instead of deducting the full cost of the patent in the year they bought it, they might amortize it over the course of its useful life (let’s say 10 years). That means they would deduct €5,000 from their income each year to reflect the decreasing value of the patent.

Changes in Working Capital: This refers to the changes in a company’s current assets (such as accounts receivable and inventory) and current liabilities (such as accounts payable and accrued expenses) during a particular period. If a company’s working capital increases during the period, it means that more cash was tied up in these accounts, which reduces operating cash flow. Conversely, if working capital decreases, it means that cash was freed up, which increases operating cash flow.

Once you have these three pieces of information, you can calculate the operating cash flow for the period by adding net income and non-cash expenses and then subtracting the changes in working capital.

It’s worth noting that operating cash flow is just one of many financial metrics used to evaluate a company’s performance. It can provide insight into a company’s ability to generate cash from its core business operations, but it should be used in conjunction with other financial measures to get a comprehensive view of a company’s financial health.

Let’s look at an example of calculating operating cash flow.

Here’s an example that helps you understand how to calculate the operating cash flow. Lets take an ABC Marketing Firm, a local business that provides social media marketing services. Here are some details about their last financial statements and performance for the year:

Net income: €50,000

Depreciation and amortization: €5,000

Accounts receivable: €10,000

Inventory: €15,000

Accounts payable: €3,000

Accrued expenses: €4,000

To calculate operating cash flow for the year, we’ll use the same cash flow formula below:

Operating Cash Flow = Net Income + Non-Cash Expenses – Changes in Working Capital

Net Income = €50,000

Non-Cash Expenses = Depreciation and Amortization = €5,000

Changes in Working Capital:

Accounts receivable increased by €2,000 during the year (€10,000 at end of year – €8,000 at beginning of year)

Inventory increased by €3,000 during the year (€15,000 at end of year – €12,000 at beginning of year)

Accounts payable increased by €1,000 during the year (€3,000 at end of year – €2,000 at beginning of year)

Accrued expenses increased by €500 during the year (€4,000 at end of year – €3,500 at beginning of year)

So the changes in working capital add up to:

(€2,000 + €3,000 + €1,000 + €500) = €6,500

Now we can calculate the operating cash flow for the year:

Operating Cash Flow = €50,000 + €5,000 – €6,500 = €48,500

Therefore, ABC Marketing Firm’s operating cash flow for the year was €48,500. This indicates that the company generated a positive cash flow from its core business operations, which could be a good sign for the business owner as well as potential investors.

This is a good moment to break out the confetti and do a little dance (or a big one, if you’re feeling really good)! A positive operating and free cash flow now is something to be proud of, and it’s a sign that your company is potentially on the right track to even greater financial success in the future.

How is cash flow forecasting related to operating cash flow?

Cash flow forecasting and operating cash flow go hand in hand. Read in this article, what is cash flow.

Cash flow forecasting is the process of estimating the amount of cash inflows and outflows a business will experience over a certain period of time. This helps you as a business owner to anticipate and plan for any potential cash shortfalls or surpluses, and make informed decisions about financing, investments, and other business activities.

Operating cash flow, on the other hand, is a calculated number of the cash generated or used by a business in its core operations. Operating cash flow is a key indicator of a business’s ability to generate cash from its core operations.

Therefore, cash flow forecasting is important because it allows businesses to anticipate their future cash needs and take action to address any potential shortfalls or surpluses. By forecasting their actual cash inflows and outflows, businesses can estimate their operating cash flow and identify potential problems before they occur. It is especially handy for businesses to help them avoid the nasty surprises that come with cash flow problems, like missed payments or unexpected expenses. It also helps them make smarter financial decisions that will set them up for long-term success.

For example, if a business forecasts a period of low cash flow, they may take steps to reduce expenses, delay payments to suppliers, or seek additional financing to cover their cash needs. Conversely, if a business forecasts a period of high cash flow, they may choose to invest in new equipment or hire additional staff to support growth.

In summary, cash flow forecasting and operating cash flow are closely related because cash flow forecasting helps businesses to estimate their operating cash flow and take action to manage their cash needs. By using both concepts together, businesses can better plan for their cash basis in the future and position themselves for success.

Try out the Tailwind demo to start using the simplest ever way to forecast your cash flow.