Financial Explainer — operating cash flow

If you want a better understanding of your financial statements, this blog is for you. We've put together a collection of blogs that explain the constituent parts in a clear and simple way.

Not all small company owners have the budget for a financial consultant or business advisor. However, they still need to put in place the right performance measures for their company and monitor the results, if they want to achieve success. Hopefully, this will help.

This blog deals with the first section of your cash flow statement — cash flow from operating activities. It's more commonly known as operating cash flow.

Let's define it.

Operating cash flow (OCF) shows how much cash your company generates from its core business activities.

It's an important measure of financial health as it tells you if your business can sustain itself (cover daily expenses and pay employees) without the need for extra funding.

The starting point for calculating your OCF is net income, i.e. your company's net profit after all expenses, including tax and interest.

Adjustments then need to be made for non-cash expenses — depreciation and amortisation. These are added back because, in accounting for them, no money actually left your business and it's only cash that you're focusing on here.

• Depreciation: This is the spreading out of the cost of the use of your physical assets, e.g. computers and machinery, etc over their expected working lives.

• Amortisation: Similar to depreciation but for intangible assets, e.g. patents, etc.

Once these are added back, you need to make adjustments for your working capital, i.e. your day-to-day cash movements. These will be set out as follows:

• Increase/ decrease in accounts receivable (money owed to you)

  • If your customers take longer to pay, your cash goes down.

  • If you collect money faster, your cash goes up.

• Increase/ decrease in accounts payable (money you owe to suppliers)

  • Delaying payments keeps money in your business for longer

  • Paying suppliers faster will reduce your cash

• Increase/ decrease in inventory

  • If inventory (stock) builds up, cash is tied up

  • When it's sold, it frees up cash

There may also be further adjustments for other non-cash expenses. These can include things like share-based payments (i.e. stock options for employees) and foreign currency (FX) changes. Although these are not relevant for most small companies.

At the end of this you'll have your OCF. In general, this is what it will tell you:

• A positive OCF means your business is generating cash efficiently.

• A negative OCF could mean that your company is struggling to turn sales into cash which could lead to funding problems.

There are some caveats for a negative OCF. It isn't always a bad sign as there are some industries and situations when it may be temporary. For example:

• High-growth companies (especially tech and start-ups)

  • These businesses tend to spend heavily on hiring, marketing and product development so they can expand rapidly.

  • Investors may support them if future profits look promising.

• Seasonal businesses (e.g. retail, tourism or agriculture)

  • Many companies make most of their sales in certain months, e.g. the Christmas period for retailers.

  • Before their peak season, they may spend a lot on stock, marketing, extra staffing, etc which can lead to a negative OCF.

  • Once sales pick up, OCF should become positive.

• Large infrastructure and construction projects

  • Again, this is when a lot of money is spent upfront, i.e. to build a rail line or power plant.

  • It can take years before cash is generated from these projects and explains why they are often tied to long-term contracts.

So there are interpretations to be made about OCF depending on the circumstances.

The key question to ask is: Will your company generate enough cash in future to cover its costs?

It's also worth remembering, if you're looking to raise finance or sell your business, that investors and lenders will look at cash flow trends over time rather than single data points as they'll want a bigger picture of how your company is performing.