How to Calculate Operating Cash Flow & Why It's Important

A business’s operating cash flow demonstrates how much money is coming in each month just from everyday business operations. Having a positive cash flow shows you that your business is doing well, while a negative one indicates you need to switch up how you’re operating.

Today, I’ll discuss how to calculate operating cash flow and why it’s vital that you keep an eye on this number over time.

Key Points:

• Calculating your operating cash flow helps you make important decisions like financing equipment or hiring additional employees.
• You can use the simpler, direct method to calculate your cash flow, or the indirect method that includes more information
• Showing your operating cash flow to your investors can help maintain confidence in your business ability. 

How to Calculate Operating Cash Flow

Calculating your business’s operating cash flow can be both simple and complicated. Let me explain. You’ll find two different methods of calculating: the direct and the indirect method. The direct method is fairly simple, while the indirect method considers more factors and can get complex if you don’t have all your paperwork in order. 

The Direct Method

Total Revenue - Operating Expenses = Operating Cash Flow

For the direct method, you only need to know two numbers: how much your business makes in revenue and how much it costs for the business to operate. So you will need to gather sales reports and expense reports, but it’s as simple as adding up and then subtracting these numbers.

This method is perfect for businesses looking to get a quick general idea of their cash flow, but it only takes a basic look at the business's financials. 

The Indirect Method

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

The indirect method takes a deeper dive. It shows you a larger picture of your business’s finances. You’re not just looking at your basic sales to operating ratio, but you also consider the cost of irregular expenses like business loans or unpaid invoices. Plus, non-cash expenses are also taken into account. Depreciation, unrealized gains or losses, and amortization are all examples.

In addition to the equation above, you’ll often find the following equation when using the indirect method. This equation considers all factors in running a business:

• Net Income + Depreciation + Stock-Based Compensation + Deferred Tax + Other Non Cash Items – Increase in Accounts Receivable – Increase in Inventory + Increase in Accounts Payable + Increase in Accrued Expenses + Increase in Deferred Revenue = Operating Cash Flow

Explanation of Operating Cash Flow Formula Components

If you’re still unsure what exactly the direct or indirect methods are, let’s break some of the more confusing terms down a bit more. 

• Net income - Your net income is how much you earn minus any taxes, material costs, employee expenses, and any other business expenses. 
• Business expenses - Business expenses include anything it takes to keep your business running. A few examples include rent or mortgage payments for your business’s space, processing fees, marketing costs, employee salaries, and the cost of materials to make an inventory or provide your service. 
• Non-cash expenses - There are other things besides physical costs you have to pay each month. Included in non-cash expenses are depreciation, amortization, taxes, and stock-based compensation. 
• Changes in working capital - In business, not everything always runs smoothly. You can expect to run into times when you have unpaid invoices or you suddenly need to buy a lot more inventory. The indirect method takes into consideration these liabilities and adds them into the equation. 

Operating Cash Flow Examples

To help you understand the real-world implications of calculating your operating cash flow, here are a couple of examples. 

Direct Method

Let’s start with the easier method. For the purpose of this example, let’s say Jack owns an ice cream shop. Below is an example of his revenue and expenses for his first quarter:

You can see here that Jack made out pretty well, gaining an operating cash flow of $49,000. 

Indirect Method

Let’s look at the same example as above. We’ll consider additional factors like the extra equipment Jack had to purchase after one of his machines broke, the self-employment tax he had to pay this quarter, and the unpaid bill left by a family that booked the shop for a party. 

This is still a simplified version of the indirect method, but it gives you a sense of how much your cash flow can change depending on the method you’re using. 

Why is Operating Cash Flow Important?

So, I’ve thrown a bunch of complicated equations at you and you’re probably wondering, does it matter that much? For business owners, yes, it absolutely matters. It gives owners an understanding of how much money they’re realistically making after all of their expenses.

With this knowledge, they can make more informed decisions for their business. In the example I used earlier with Jack, he likely calculated his cash flow before deciding to take out a loan for his new ice cream machine. That way he could know how much he had available to realistically spend on monthly payments.

And it’s not just business owners that can use these calculations. Investors interested in investing in your business can ask you for these numbers so they can ensure they’ll get a good return on their investment. The same goes for any lenders you could work with. They’ll likely ask to see your cash flow statements so they know you have the ability to repay your loans.