What is operating cash flow? A small business owner’s guide

Knowing your operating cash flow (OCF), the liquid cash generated by your business activities  in a given period, will help you monitor the health of your small business finances, and support important decisions such as whether or not to seek outside financing.

For most small merchants in the UK, being able to maintain stock and keep your day-to-day operations running requires a certain level of liquid, accessible cash.

If you’re unsure of how to monitor this important figure or optimise it for your unique business needs, here’s a closer look at what operating cash flow is, how to calculate operating cash flow, and how to use it as part of your small business strategy.

What is operating cash flow: a quick overview

Is operating cash flow the same as free cash flow?

Operating cash flow (OCF) shouldn’t be confused with free cash flow (FCF), which considers variables outside your core operations.

While operating cash flow measures the cash generated from your business’s core activities, free cash flow is determined afterwards by subtracting your capital expenditures from your operating cash flow.

Because operating cash flow is a direct measure of how much cash you’re generating from your activities, it should be treated as an essential part of your cash flow statement, and a key indicator of your business’s overall financial health.

When you have positive operating cash flow, you’ll have the financial flexibility to pay your business debts, keep basic operations running, and invest in your long-term business growth strategy.

A persistently negative operating cash flow, on the other hand, can signify an inability to cover the basic activities that keep your business running.

Is negative operating cash flow bad?

Negative operating cash flow can be a warning sign, indicating that a business is not generating enough cash from its operations to cover all of its expenses.

However, there are situations where a negative operating cash flow is acceptable, for example for new businesses or those investing heavily in their future growth.

Calculating operating cash flow

There are 2 methods you can use to calculate the operating cash flow for your small business: direct and indirect.

Both methods have their own respective pros and cons and are better suited for different applications as part of your internal and external financial reporting.

Operating cash flow formula (direct method)

The direct calculation method uses data from cash inflow and outflow within a given reporting period, drawing data from important instances of cash receipts and payments.

These instances will include cash receipts from sales, payments to suppliers, employee wages, interest paid on business loans, and other expenses involved in the day-to-day running of your small business.

The direct method provides a clear picture of the cash coming in and out of your business, and is useful for reporting cash flow to external parties such as private investors or bodies offering small business grants.

However, because it requires detailed reporting of your cash receipts and expenses, organising the data you need to carry out this calculation can be more labour-intensive, requiring robust small business accounting.

You can calculate your operating cash flow using the direct method with the following operating cash flow formula:

Operating cash flow formula (indirect method)

The indirect method of calculating operating cash flow accounts for changes in working capital non-cash items like depreciation.

This allows you to arrive at an operating cash flow that covers variables such as accounts receivable and inventory, depreciation, and other non-cash items.

Combining these items with the net income from your income statement, you can calculate an operating cash flow figure.

Because the indirect method uses data points that are already included in your business’s income statement, and doesn’t require the same level of detail as the direct method, an indirect operating cash flow calculation tends to be the easier of the 2 methods to carry out.

However, an indirect operating cash flow can be less accurate compared to a direct calculation figure, and is less suitable for sharing your small business financial analysis with external parties like investors.

You can calculate your operating cash flow using the indirect method with the following operating cash flow operating cash flow formula:

Practical tips for operating cash flow

While operating cash flow is only one part of your accounting, it’s a crucial indicator of your financial health and productivity as a UK merchant.

As a small business owner, you should proactively work to maintain a positive operating cash flow, and take preventative measures to avoid slipping into a negative operating cash flow.

Here are some practical tips you can use to maintain a strong operating cash flow and ensure the long-term financial health of your small business.

Using operating cash flow to inform business decisions

Though operating cash flow is certainly important as a basic health check of your business’s finances, it can also be a very useful tool for planning for the future of your business.

By understanding the variables that affect your operating cash flow, you can make sure that your business growth strategy is addressing your biggest challenges as a merchant.

Some of the key decisions which you should consider referencing your operating cash flow include:

• Setting your business budget and highlighting areas where you’re spending more cash than necessary, ensuring that you’re reducing expenses and avoiding overspending.

• Making investment and business expansion decisions, and using your operating cash flow to determine whether you have sufficient liquid cash to invest in new business activities, e.g. launching a new product or opening a new branch.

• Perform internal spending reviews and audits using your records of cash inflows and outflows.

• Keeping track of your business’s liquidity for more effective contingency planning.

By using your operating cash flow as a reference point for decision-making, you can ensure that your strategy reflects the financial reality of your business, and avoid the risk that comes with making choices that are more based on intuition.

Regular revenue

In order for your small business to survive, it needs to maintain a consistent revenue stream supporting its operating cash flow.

However, many businesses undergo fluctuations in their revenue throughout the year, stemming from seasonal trends, economic factors like inflation, pressure from competitors, and other factors.

As a UK merchant, you can mitigate the effects of these fluctuations by building a liquid cash reserve. This can be used as a financial safety net during slow business periods, and ensure that you have a strong small business budget to cover your essential business operations.

If, for example, you’re running a hand-crafted gifts store, you may find that your sales volume tends to increase in the period immediately before Christmas, then experience a slump in January.

By designating some of the profits made in the holiday period to build an emergency cash reserve, you’ll be able to cover your basic operations without having to use your personal finances or apply for a loan to bolster your working capital.

Low overhead costs

Keeping your overhead costs as low as possible is another effective practice for managing your cash flow from operations and maintaining a positive OCF.

As a merchant, you should be in the habit of regularly reviewing your small business expenses, and finding ways that you can reduce costs while still maintaining a high standard of product quality and service to support customer retention.

If you’re running a restaurant, for example, you may be able to identify several areas where you’re paying more than necessary to keep your business operational, such as your utility bills or over-ordering ingredients which end up being wasted.

By developing better demand projections, or switching to more energy-efficient kitchen equipment, you can reduce your overhead expenses and access cash to support your operating cash flow.

Reassessing your staffing needs is another area where you may be able to make significant savings to help your operating cash flow, for example by concentrating staff schedules on peak times and allocating fewer working hours during slow periods of the day.

Finding small savings across all possible areas in your business’s operations can quickly add up to larger savings, giving you a stronger operating cash flow and more flexibility to cover your business expenses.

Avoid delays in customer payments

If you’re operating within a business-to-business (B2B) model, then you may have payment terms that allow your clients or customers to pay for products or services after they receive them, rather than immediately, as is more common in business-to-customer (B2C) retail models.

If these payments are delayed too often, it can lead to a significant strain on your operating cash flow. With this in mind, it’s important to have measures in place that minimise the length and frequency of delays.

When running an independent bakery that caters for large events, you may want to offer a small discount on the customer’s total invoice if they pay within 10 days, instead of running longer into the 30-day maximum payment term.

By using an initiative like this, you can encourage more of your customers to pay quickly, increasing your liquid cash and making it easier for you to cover the cost of baking and delivering future orders.

It’s also best practice to implement strict policies when it comes to payments, and ensure you’re clearly communicating your payment terms to customers, including the penalties for overdue invoices.

Inventory management

Effective inventory management is closely tied to cash flow management.

Overstocking inventory can freeze cash which could potentially be used to cover operating expenses. Understocking, on the other hand, can limit your sales volume. Because of this, maintaining a balance with a robust inventory management system is crucial for any merchant looking to maintain their operating cash flow.

If you’re running an independent retail shop, for example, you may find that certain products are underperforming according to your sales projections.

Instead of investing in these underperforming items, you can use point of sale data insights to bolster your inventory management by focusing on stocking better-selling items, and adjusting the orders to your suppliers to reflect this demand.

This will not only reduce the cost of ordering items that may not sell, but lower the long-term storage costs for your total inventory.

Using these strategies to reduce the recurring costs of maintaining your inventory, while still making sure you have enough inventory for popular items and peak periods, you’ll be able to avoid many common cash flow issues associated with over and under-stocking.

Account for seasonal fluctuations

Many businesses see recurrent and unavoidable cash flow fluctuations in their year end accounts.

Being able to anticipate these fluctuations, and plan ahead to mitigate their effects on your profits, will help you achieve a more consistently healthy operating cash flow.

If, for example, you’re running a water sports equipment rental business that’s particularly active in the summer, your small business accounting tools will likely show an increase in sales in the summer and a lower volume in the winter.

When looking at how to improve cash flow for a seasonal business, you can divert more of your resources to the busiest part of the calendar, and reduce spend in the slow winter months through initiatives like reducing staff hours or negotiating temporary reductions in your premises rent.

By taking proactive measures, you’ll minimise the negative impact of slower business periods and maintain a positive operating cash flow throughout the year, reducing the need for loans.

Accurate forecasting

Having an accurate cash flow forecast as part of your basic financial reporting will also provide valuable support when you’re looking into how to calculate cash flow from operating activities and avoid financial instability.

Without effective cash flow forecasting, you could run the risk of overestimating your net cash flow or underestimating the operating expenses you need to cover. Countering this with effective forecasting can help you avoid negative operating cash flow, and bolster your ability to cover your expenses.

If you’re a small cafe owner, you might plan to run a seasonal promotion in the period before Christmas, for example offering a free festive cookie with purchases above a certain value, and anticipate an increase in sales based on this.

However, if you fail to forecast the additional cost of running this promotion, for example through a localised email marketing or social media marketing campaign, you could find yourself in an unexpected cash flow deficit that has negative effects on other areas of your business.

To avoid the risk of negative cash flow, you should plan to adopt robust cash flow forecasting tools that help you to simulate different probable outcomes for your business’s future, and give you the information you need to plan for the best and worst-case scenarios.

Debt management

Some small businesses operate under some kind of debt, whether that’s an initial business loan that’s allowed you to start a business in the first place, or additional lines of credit you’ve used to realise a business growth strategy.

Like your other expenses, keeping up with debt repayments each month can have the potential to eat into your profits, and leave you with less free cash for you to invest in your business. This is especially true if you’re having to cover the payments on a high-interest loan.

If you started a food truck business by taking out a high-interest loan for the vehicle and essential equipment, making the monthly repayments could cause a strain on your cash flow, and lead to thinner profit margins.

In this scenario, prioritising debt repayments above other purchases, or refinancing at a lower interest rate if necessary, could help you manage your debt and mitigate its long-term impact, making it easier to maintain a positive operating cash flow.

Disclaimer: The contents of this page are intended for informational purposes only and should not be construed as professional advice. For matters requiring legal or financial expertise, it’s recommended to seek guidance from qualified professionals.