Understanding operating cash flow

Operating cash flow

Operating cash flow is the first section of a cash flow statement (which also includes cash flow from financing and investing activities).In short, operating cash flow is the amount of cash that a business generates through its regular operating activities within a certain timeframe. It helps determine whether a business has enough cash to cover expenses and plan for future growth.

There are two common ways that businesses can calculate operating cash flow. The first one is the direct method, which is used for cash-based accounting. To calculate the direct method, you take revenue and minus operating expenses. This does not include income from capital gains (investments) but shows how well your business is performing from primary activities.

So, if your balance is negative, this means that you have more money coming out of your business than coming in - and you may need to look at cash flow management.

The second way to calculate operating cash flow is by using the indirect method, which is more common and accrual-based. This is more complex but takes into account changes in assets and liabilities, as well as non-cash expenses. The formula to calculate the indirect method is listed later in this article.

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Cash flow operating activities

Cash flow from operating activities shows how much money a business brings in from regular business pursuits, whether that’s selling goods, manufacturing, or providing a service to customers.

It focuses only on the core business and does not include long-term capital expenditures or investment revenue and expenses. Examples of cash flow from operating activities include cash receipts from:

• collection of receivables
• sale of goods and services
• lawsuit settlements
• licensees
• settlement of insurance claims
• supplier refunds.

This type of cash flow is crucial as it enables businesses to pursue opportunities that may enhance shareholder value. Without this cash, it's difficult to reduce debt, make acquisitions, develop new products or pay dividends.

Operating cash flow formula

As mentioned previously, there are two common ways that businesses can calculate operating cash flow. The first one is the direct method, which is used in cash-based accounting. The formula for the direct method is:

Direct method: operating cash flow = total revenue - operating expenses

The indirect method, which is more common, takes several other factors into account. While it is more complex to calculate, it also considers non-cash considerations such as depreciation and amortisation. The formula for the indirect method is:

Indirect method: operating cash flow = net income + non cash-expense +/- changes in assets & liabilities.

You’ll need to make adjustments for depreciation, increases in accounts receivable, and other non-operating and non-cash expenditures from your net income. You should also use data from the same accounting period, or you’ll likely get inaccurate results.

Operating cash flow ratio

The operating cash flow ratio measures how well the cash generated from ongoing activities covers your business’s liabilities. It can help you gauge your short-term liquidity. To help you calculate your company's operating cash flow ratio use this formula below:

Operating cash flow = net cash from operations ÷ current liabilities.

An ideal ratio should be greater than 1:1. For example, if net cash flow from operations is £100,00 and current liabilities is £80,000, the ratio would be 1.25:1.  

A ratio below 1 means that a business spends more than it makes from its operations and is likely to be experiencing cash flow problems. The higher the number is, the more cash your business is making.

How to improve cash flow from operations

There are several ways you can improve cash flows from operations, including:

• collecting on overdue invoices
• offering discounts to incentivise early payments
• increasing your inventory turnover
• paying suppliers on time
• carrying out customer credit checks
• raising your prices
• forming a buying cooperative
• collecting business payments more easily with iwocaPay.

It’s also important to make good decisions when it comes to product development, customer service, and both your customer acquisition strategy and marketing efforts.

Read more on cash flow

• Download our cash flow forecast template
• What is free cash flow?
• How to calculate discounted cash flow

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How iwoca can help improve your operating cash flow

Slow-paying customers aren't good for your operating cash flow. With iwocaPay, you can get your invoices paid sooner. Your customers can choose to spread their invoice payments across 3 months, while you get paid upfront every time. Plus, we’re integrated with Xero, allowing you to provide a simple invoice checkout to all of your B2B customers.

To find out more about how iwocaPay can help your business, call us today on 02037780629 or email us at support@iwoca.co.uk

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