All businesses operate with a major constraint: money coming in must equal or exceed money going out. It might take months or even years to accomplish this goal, which is why understanding your company’s cash flow is critical.
There are two main methods of measuring cash flow in your organization: operating cash flow and free cash flow. Both are prominent metrics to compare your business with competitors within the same or similar industries.
This article explains the difference between these two common metrics and how to calculate the cash flow for your own business. After all, understanding these measurements determines whether your company is generating the cash it needs to invest in its future.
Operating Cash Flow
Operating cash flow or OCF is the cash a company generates from normal business activities within a certain period. This measurement shows how much money is generated from business operations without considering factors such as interest or investments.
Normal business operating costs include the Cost of Goods Sold or COGS, expenses that directly correlate with the income from selling those same goods. In addition, less directly-correlated expenses such as marketing, advertising, rent, insurance, and administrative overhead are also part of operating costs and fall into a grouping typically referred to as Sales, General, and Administrative or SG&A.
OCF keeps track of all money coming in and going out and is recorded in the company’s cash flow statement. Sometimes OCF is listed as “cash flow from operating activities” and represents the cash impact on a company’s net income.
If your company requires a small business loan, many lenders will look at your OCF to ensure you bring in enough money to pay your bills and ascertain your ability to repay the loan.
Operating Cash Flow Calculation
The operating cash flow formula can be calculated two different ways under GAAP or Generally Accepted Accounting Principles.
Direct Method
Indirect Method
Net Income: Net income is how much your business earns from its operations. Find net income by taking the company’s total revenue minus all expenses.
The indirect method is a lot more complicated, but it gives more information.
Free Cash Flow
Operating cash flow has its limitations because it doesn’t take into account the cost of acquiring and managing fixed assets such as machinery, software, furniture, and vehicles.
Free cash flow or FCF measures how much cash a company generates from normal operations minus any cash spent for long-term fixed assets.
Understanding how much money you have leftover after paying for everything is valuable because you can assess how much money you may reinvest back into the company.
It also has the potential to identify red flags in your accounts receivable process. For example, if revenue increases but free FCF is not, it could mean customers are not paying invoices on time.
Free Cash Flow Calculation
FCF can show you how much you have after paying interest expenses during a period. However, it will not reflect newly acquired, or old debt recently paid off.
Free cash flow is a measure of financial performance, similar to earnings, and although it can be useful, it’s not a part of any of the core financial statements included in GAAP reporting.
Summary
Operating and free cash flow are essential metrics for financial health and sustainability. While they each tell you different information, together, they illustrate a more significant picture representing your financial health.
As sales increase, so do your operating costs, which makes understanding cash flow more powerful. Without proper cost controls and tight cash flow management, increasing sales may not improve net income.
Regardless of which method you choose for your organization, it is vital for management to assess these metrics in order to have a clear awareness of money generated. This data will help determine if a company can hire more staff, purchase better equipment or software, and invest in growth overall.
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