Young male business owner How to Calculate Operational Cash Flow and Why You Should
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How’s your operational cash flow? If you aren’t sure, now might be the time to take a closer look at the money flowing into and out of your business. Learn how to calculate your operational cash flow ratio and how doing so will help you keep tabs on your cash flow.

Cash Flow in Your Small Business

If you ask any fledgling business owner what their biggest challenge is in the early days of the business, most will say getting cash flow positive. In fact, a US Bank study found that 82% of small businesses fail directly due to cash flow problems.  And a recent JP Morgan Chase study found that most small to medium size businesses have just enough cash to cover 27 days of expenses. That isn’t even one full month.

Once your business starts getting new accounts and making sales, you should start seeing money flowing in. And as your business gets established, you’ll start to see patterns emerge. You’ll get a feel for estimating your sales numbers based on your work and production. And this is where operational cash flow comes in.

What is Operational Cash Flow (OCF)?

Before making the calculation for your own business, it’s important to understand just what this ratio represents. Basically, your OCF ratio is a liquidity ratio. And it is an indication of the financial stability of a business.

Your OCF measures the cash generated by your company’s regular business operations. It compares the cash flowing in to your business against the cash currently flowing out. 

Your operating cash flow suggests whether your business could produce enough positive cash flow to keep your business afloat and also grow. What if your operational cash flow can’t keep your business chugging along and growing too? This means you might need to get business loans or other financing to grow your business.”

Why Business Owners Should Keep an Eye on OCF

Today’s business owner juggles many balls – sales, operations, marketing, advertising, and human resources, to name a few. Why spend time calculating a cash flow ratio anyways?

Here’s why. Your OCF gives you (and your creditors, investors, accountant, or business financial advisor) some insight into the health of your core business activities. If your business doesn’t have a positive cash flow, it’s a sign your company will run into trouble in the long run. As in, you won’t have enough money coming in to cover your expenses and keep your doors open. Unless you financed your business by borrowing more money or take on investors to bring in extra capital

Another reason to review your OCF ratio is that it gives you a more accurate reporting of the actual cash on hand available to meet your operational expenses and bills. That’s because it’s based on the actual payments received, and not on sales made. True, one big sale could inflate your revenue numbers. However, that sale doesn’t really make a difference to your business financially. At least not until you get paid.

Where to Get the Numbers to Calculate Your OCF Ratio

You’ll find all the information you need to calculate your operating cash flow right in your financial statements and accounting records. Your cash flow from operations might show up on your Statement of Cash Flow. If not, you’ll find instructions on how to calculate it further down the page. And you should find your current liabilities in your financial statements. If not, check your accounting records.

How Do You Calculate Operating Cash Flow?

Operational cash flow gets calculated using an equation. It’s simply Cash Flow From Operations divided by Current Liabilities. This calculation generates a number that represents your operating cash flow.

Operational Cash Flow = Cash Flow From Operations/Current Liabilities

In simple terms, the OCF calculation uses your operating income before depreciation, minus taxes and adjusted for changes in working capital. Any other activities get excluded or separated from the Operating Cash Flow calculation. These include financing activities such as issuing dividends, issuing or purchasing common stock, issuing or purchasing debt securities. They also include investing activities like capital expenditures or acquisitions. 

The OCF formula also uses your current liabilities. Include any short term debt, accounts payable, and any accrued liabilities in your calculations.

Calculate your OCF ratio using either one of these formulas for Cash Flow From Operations.  For most purposes, use the general OCF formula as it’s simpler to calculate.

General Cash Flow From Operations Equation

Don’t let the length of this equation scare you off – it really isn’t difficult to complete.

Operating Cash Flow (OCF) = Operating Income (revenue – the cost of sales) + Depreciation – Taxes +/- Change in Working Capital

General Long Form Cash Flow From Operations Equation

Operating Cash Flow = 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

Parts of the Formula

Operating Income: The profit from your operations, after operating expenses like wages, depreciation, and cost of goods sold (COGS)

Depreciation: The Oxford English Dictionary defines depreciation as a reduction in the value of an asset with the passage of time, due in particular to wear and tear.

Changes in Working Capital: Working capital has a  simple definition. It’s just current assets minus current liabilities. And changes in working capital refers to the difference in the net working capital amount from one accounting period to the next. 

An Example of an Operating Cash Flow Ratio

Let’s say your business generates $300,000 cash flow from operations. And you have $240,000 in current liabilities. Your operating cash flow ratio is 1.25. This means that based on your current cash flowing into your business, you could cover your current liabilities 1.25 times. The cash flowing into the business will more than cover the money flowing out. You’ll even have money left over.

Another way to look at it is that for every dollar of money you owe, you’re bringing in $1.25. And either way, that’s good. What if you want to expand your business? Is an operating cash flow ratio of 1.25 enough to do so? Maybe not. It might benefit your business to borrow money for a capital expansion. This could let you grow your business faster.

Operating Cash Flow Ratios Below 1.0

What does it mean if your cash flow ration falls below 1.0? This suggests a cash flow issue. In other words, you don’t have money coming in to cover your short-term liabilities. Your business will need to increase the incoming cash or borrow to cover the shortfall. However, borrowing in this situation could be tricky, because creditors don’t like to see an OCF ratio of less than 1.0. And keep in mind that borrowing money as a solution to short term cash flow woes won’t help your business in the long run.

The Difference Between Operational Cash Flow and Net Income

At first glance, it may seem that operational cash flow and net income are very similar. Yet they aren’t the same.

Net income gets calculated as business revenue minus expenses, taxes, and cost of goods sold. On the other hand, your operational cash flow figure gets calculated as the cash generated from your business operations, less the current liabilities. The key difference has to do with the timing. While net income focuses on revenue, the cash that “revenue” generated might not yet have been collected.

Keeping an eye on your OCF ratio on a regular basis lets you see patterns and trends early on, giving you a chance to address cash flow issues quickly. And creditors and investors look at operational cash flow to get a clear picture of a business’ current financial health. Sales, revenue, and accounts receivables are indeed important business figures. Yet they don’t  help your business until they turn into operating cash. After all, you can’t pay bills with money you don’t yet have in the bank.

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