Operating Cash Flow (OCF) Explained: Formula and How to Improve

Operating cash flow (OCF) measures the amount of cash a business generates from its core operations. It reflects whether a company can sustain its day-to-day expenses without relying on external financing, making it a critical indicator of financial health. Unlike net income, which includes non-cash accounting adjustments, operating cash flow focuses solely on actual cash movement.

For businesses, maintaining strong operating cash flow is essential for covering expenses, funding growth, and managing financial stability. If a company consistently struggles with cash flow, it may signal deeper financial issues, even if it appears profitable on paper. Understanding how to calculate, interpret, and improve operating cash flow can help business owners make informed financial decisions.

What Is Operating Cash Flow?

Operating cash flow (OCF) represents the cash generated by a business’s core operations, excluding financing and investing activities. It measures how efficiently a company turns its revenue into actual cash, making it a key metric for assessing financial stability.

Unlike net income, which includes non-cash expenses like depreciation and accounts for accrual-based accounting adjustments, OCF focuses purely on cash movement. A business with strong operating cash flow can cover its expenses, reinvest in growth, and handle unexpected costs without relying on external funding.

Operating Cash Flow vs. Other Cash Flow Metrics

• Operating Cash Flow vs. Net Income – Net income includes non-cash expenses and can be affected by accounting practices, while OCF reflects actual cash available for operations.
• Operating Cash Flow vs. Free Cash Flow (FCF) – FCF goes a step further by subtracting capital expenditures (CapEx) from OCF, showing how much cash is left after reinvesting in the business.
• Operating Cash Flow vs. Total Cash Flow – Total cash flow includes cash from all activities: operating, investing, and financing. OCF focuses solely on operational efficiency.

By focusing on operating cash flow, business owners and investors can gauge whether a company is financially sustainable and capable of generating enough cash to support ongoing operations.

How to Calculate Operating Cash Flow

Operating cash flow (OCF) can be calculated using two primary methods: the direct method and the indirect method. While both arrive at the same result, they take different approaches to determining cash flow from operations.

Direct Method

The direct method calculates OCF by summing up actual cash transactions related to core business activities. It focuses on cash received from customers and cash paid for expenses such as wages, rent, and supplier payments.

Formula:

Operating Cash Flow = Cash Received from Customers – Cash Paid to Suppliers and Employees – Operating Expenses – Taxes Paid

Example:

A company collects $500,000 from customers, pays $200,000 to suppliers, $100,000 in wages, and $50,000 in taxes.

OCF Calculation:
$500,000 – $200,000 – $100,000 – $50,000 = $150,000

Indirect Method

The indirect method starts with net income and adjusts for non-cash expenses and changes in working capital to determine operating cash flow. This approach is more commonly used, as financial statements are typically prepared using accrual accounting.

Formula:

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

Common adjustments include:

• Adding back depreciation and amortization, since these expenses don’t involve actual cash outflows.
• Adjusting for changes in accounts receivable, inventory, and accounts payable, which affect cash availability.

Example:

A company reports $120,000 in net income, with $30,000 in depreciation and a $10,000 increase in accounts payable.

OCF Calculation:
$120,000 + $30,000 + $10,000 = $160,000

Which Method Is Better?

While the direct method provides a clearer view of cash inflows and outflows, the indirect method is more widely used because it aligns with accrual accounting. Most businesses and investors rely on the indirect method for consistency in financial reporting.

Why Operating Cash Flow Matters

Operating cash flow (OCF) is one of the most important financial metrics for assessing a company’s ability to sustain its operations. Unlike profit, which can be influenced by accounting adjustments, OCF shows the actual cash generated by a business. A strong OCF indicates that a company can cover expenses, reinvest in growth, and manage financial obligations without relying on external financing.

1. Measures Financial Health

OCF provides a clear picture of whether a business is generating enough cash from its core operations. A consistently positive OCF suggests financial stability, while a negative OCF may indicate cash flow problems, even if the company reports a profit.

2. Helps in Business Decision-Making

Companies with strong operating cash flow can reinvest in the business, expand operations, or pay down debt without taking on additional financing. A weak OCF, on the other hand, may signal the need for cost-cutting measures or strategic adjustments.

3. Used by Investors and Lenders

Investors and lenders closely analyze OCF when evaluating a business. A positive and growing OCF is often seen as a sign of a well-managed company, while a declining OCF may raise concerns about liquidity and long-term sustainability.

4. Indicates Ability to Handle Debt

Businesses with strong operating cash flow are better positioned to meet loan obligations and manage debt repayments. Lenders often look at OCF to determine whether a company can handle additional borrowing.

5. More Reliable Than Net Income

Since net income includes non-cash expenses like depreciation and amortization, it doesn’t always reflect actual cash availability. OCF, on the other hand, focuses on real cash movement, making it a more reliable indicator of a company’s financial position.

Operating Cash Flow vs. Net Income

While both operating cash flow (OCF) and net income measure a company’s financial performance, they represent different aspects of a business’s financial health. Net income reflects accounting profits, while OCF shows the actual cash generated from business operations. Understanding the differences between the two is essential for evaluating a company’s ability to sustain itself financially.

Key Differences Between Operating Cash Flow and Net Income

Operating cash flow provides a real-time look at a company’s ability to generate cash, while net income is based on accounting principles that can sometimes obscure a company’s actual financial position. A business might appear profitable on paper but struggle with cash flow due to uncollected revenue, excessive expenses, or high debt obligations. Below are the main distinctions between the two metrics.

1. Net Income Includes Non-Cash Expenses, While OCF Reflects Actual Cash

Net income is calculated using accrual accounting, which includes non-cash expenses like depreciation, amortization, and stock-based compensation. These reduce reported profits but don’t impact cash flow. OCF adds these expenses back to show how much cash the business actually generates.

2. Net Income Accounts for All Revenue, OCF Adjusts for Cash Timing

Revenue recorded in net income may not have been collected in cash yet. For example, if a company sells a product on credit, that revenue appears in net income but won’t be reflected in OCF until the payment is received.

3. Working Capital Changes Impact OCF, Not Net Income

OCF accounts for changes in accounts receivable, accounts payable, and inventory, which can significantly impact cash availability. A business may report strong profits but struggle with cash flow due to slow customer payments or excessive inventory.

Example: Net Income vs. Operating Cash Flow Calculation

Scenario: A company reports $200,000 in net income. However, after adjusting for non-cash expenses and working capital changes, the actual operating cash flow looks different:

• Depreciation: +$30,000
• Increase in Accounts Receivable (money owed to the business): -$20,000
• Increase in Accounts Payable (money the business owes): +$15,000

OCF Calculation: 200,000 + 30,000 − 20,000 + 15,000 = 225,000

In this case, the business has $225,000 in actual operating cash flow, which is higher than net income due to the adjustments.

Why OCF Is Often More Reliable Than Net Income

While net income is useful for measuring profitability, operating cash flow provides a clearer picture of a company’s ability to sustain its operations and manage liquidity effectively.

• More difficult to manipulate: Accounting rules allow for earnings adjustments, but cash flow is harder to artificially inflate.
• Shows real cash availability: Helps businesses assess if they can cover short-term expenses.
• Preferred by investors and lenders: Many financial analysts focus on OCF instead of net income when evaluating a company’s financial health.

How to Improve Operating Cash Flow

A strong operating cash flow (OCF) allows businesses to cover expenses, reinvest in growth, and maintain financial stability. If a company’s cash flow is weak, even a profitable business can struggle to pay its bills or meet short-term obligations. Improving OCF requires optimizing revenue collection, controlling expenses, and managing working capital efficiently. Below are key strategies to enhance operating cash flow.

1. Speed Up Accounts Receivable Collection

Delayed customer payments can create cash flow gaps. Businesses can improve OCF by accelerating how quickly they collect outstanding invoices.

• Offer early payment discounts to incentivize customers to pay sooner.
• Use automated invoicing systems, such as Wave, to send invoices promptly and track payments.
• Follow up consistently on overdue accounts to reduce collection delays.

2. Manage Expenses More Efficiently

Reducing unnecessary expenses can free up more cash from operations. Businesses should regularly review their spending and eliminate costs that do not contribute to growth or operational efficiency.

• Negotiate better terms with suppliers to reduce costs or extend payment deadlines.
• Cut discretionary expenses that don’t directly impact business performance.
• Switch to more cost-effective service providers for utilities, software, or outsourced work.

3. Optimize Inventory Management

Holding excess inventory ties up cash that could be used elsewhere. Improving inventory turnover can help businesses maintain liquidity without overstocking.

• Use demand forecasting to ensure stock levels align with sales trends.
• Implement just-in-time (JIT) inventory practices to minimize excess stock.
• Identify slow-moving inventory and offer discounts to free up cash.

4. Extend Accounts Payable Without Penalties

While businesses should avoid late payments, strategically extending payables without incurring fees can help maintain cash reserves.

• Take full advantage of supplier payment terms (e.g., net 30 or net 60).
• Consolidate purchases with key vendors to negotiate better payment terms.
• Avoid early payments unless significant discounts are offered.

5. Reduce Reliance on Short-Term Financing

While loans and credit lines can help with short-term cash flow issues, excessive reliance on financing increases debt obligations and interest expenses. Instead, businesses should focus on improving their operational efficiency to generate cash internally.

• Reinvest in revenue-generating activities.
• Use cash flow projections to plan for future needs instead of relying on emergency credit.
• Prioritize paying down high-interest debt to free up cash in the long run.