Income can come from a variety of activities, including financing and investments. Everyday business operations are typically the foundation of a small business’s income, but, if you’re only focusing on the income on your financial reports, you might be getting a misleading picture of your company’s health. This is why it is important to identify your company’s operating cash flow. Knowing your operating cash flow helps you judge the efficiency of your operations, make decisions about future investments, and protect your company from market shifts and unforeseen challenges.
Operating Cash Flow
Whether you offer services or sell goods, your operations are the primary activities of your business; operating cash flows include the cash inflows from these activities and the cash expenditures that fund them. Not all revenue and expenses directly affect cash flow, though. Depreciation expenses and accounts receivables are some examples of items you can report as revenue and expenses without any cash changing hands. A company with a lot of depreciation and receivables on the books but not a lot of cash coming in may look healthier than it actually is, which is why it’s important to understand how to calculate operating cash flow.
Calculating Operating Cash Flow
The basic idea of operating cash flow is straightforward: Subtract the cash flowing out to support operations from the cash coming in from operations. As your business grows and expands, you may find that it the reality isn’t so simple. Factors that can complicate this include accounting for things that hold up incoming cash flows, such as extended payment terms, installment payments, returns, and late payments. The expense side can also be unclear, as you try to separate expenses that apply or don’t apply to operations, such as finance and investment expenses – or expenses that don’t relate to cash flow, such as deprecation.
The Indirect Method
Because of these complications, many businesses compute operational cash flow using the indirect method. With this method, you start out with your net income, and then back into cash flow by adjusting for any items that affect net income but don’t derive from operations or cash flow.
- To net income, add non-cash expenses, such as depreciation.
- Add any losses on the sale of assets.
- Subtract any gains on the sale of assets.
- Add in any increases to current liabilities, such as income taxes payable, and any decreases in your current assets, such as lower accounts receivable balances.
- Subtract any increases in current assets and decreases in current liabilities.
Resources for Calculating Cash Flow
There are tools, including apps and pre-filled templates, that can help you calculate operating cash flow. You can find interactive tools built in to accounting software that make it easier to forecast future cash flow, such as QuickBooks Desktop’s cash flow forecaster, an interactive tool that helps you identify cash flow items and creates projections across a custom date range.
Maintaining Healthy Cash Flows
Once you know your operating cash flow, you can use it as a metric to judge your operations and forecast future cash flows. This is especially helpful if you’re operating a goods-based business, where physical assets, such as buildings and equipment, are an important part of your net income but may distort the amount of cash that is actually flowing through your business. Maintaining a healthy cash flow gives you more options when you’re making business decisions. A healthy cash flow is especially attractive to potential investors – it shows that you can quickly adapt to future changes, ensuring a brighter long-term outlook and less vulnerability to risk.
Shielding Your Company From Market Forces
Maintaining positive cash flow can be critical to managing demand downturns and other external market factors. Even commodity juggernauts can be vulnerable. Investors saw early warning signs for Canadian Oil Sands when its cash flow failed to meet expectations in 2013, with the company announcing that it predicted a cash inflow of $1 billion. Those projections paled in comparison to the $2 billion in projected cash outflows. The company had assets to weather the shortfall, but when low global prices came in the following years and cash on hand was dwindling, it was vulnerable to buyout. Suncor Energy acquired the weakened company in 2016. The same market challenges also affected Suncor Energy, but the company maintained a 10-figure positive annual cash flow during the global slump, putting it into a position where it could stay afloat and make acquisitions.
While billions of dollars of incoming cash may seem like a nice problem to have for the small business entrepreneur, the principles apply on any scale. Any business is subject to outside market forces, and when winds change, companies with strong cash flows can stand out as the big fish in a shrinking pond. By learning how to identify and calculate your operating flow – and using that knowledge to measure your performance, invest wisely, and brace your company for the future – you can set yourself apart in your field.