What it means
Profit and cash are not the same thing. A company can report a profit while running short of cash if customers pay slowly or if it has to buy a lot of stock, and it can report a loss while still generating cash if it has large non-cash costs such as depreciation.
Operating cash flow cuts through this by focusing on the actual movement of money. It appears as the first section of the cash flow statement, usually labelled cash from operating activities.
There are two methods of presenting it. The indirect method begins with net profit and adjusts for non-cash items and changes in working capital, while the direct method lists cash received from customers and cash paid to suppliers and employees.
Working capital changes are the part that surprises many managers. When receivables (money owed by customers) go up, cash is tied up and operating cash flow falls, while when payables (money the company owes suppliers) go up, the company is effectively borrowing from suppliers and operating cash flow rises.
Inventory increases reduce cash in the same way as receivables. Lenders, investors and boards pay close attention to this number because it is harder to manipulate than profit.
A business that consistently reports profit but weak operating cash flow may be recognising revenue too early, collecting slowly or carrying too much stock. A healthy business usually has operating cash flow that is close to or higher than net profit over time.
Operating cash flow excludes spending on equipment and property, which is shown under investing activities, and excludes loans and dividends, which are shown under financing. For this reason, analysts often subtract capital spending from operating cash flow to arrive at free cash flow, a measure of what is left for owners and lenders.
In forecasting, many finance teams build a monthly operating cash flow projection alongside the profit budget. They test it with different assumptions about customer payment days and stock levels, since small changes in those can swing the result by large amounts.
This gives early warning if the business will need extra funding.
In practice
Real-world examples
Example 1
A wholesale distributor grows sales by 30% and reports a record profit. Its customers pay in 60 days, so receivables balloon and operating cash flow is negative. The owner arranges a short-term credit line to bridge the gap while collections catch up.
Example 2
A software company sells annual subscriptions and collects the money in advance. Its net profit is small because it is spending heavily on development, but deferred revenue increases and operating cash flow is strongly positive. The chief financial officer uses the cash to fund expansion without borrowing.
Example 3
A lender reviewing a manufacturer's loan application looks first at operating cash flow over three years. It sees $400,000, $430,000 and $460,000, steadily covering the interest bill of $90,000. The loan is approved on standard terms.
Think of it
Operating cash flow is the actual cash your business generates from selling products and services-the real money, not accounting profit.
Formula
Calculation
Operating cash flow = net income + non-cash expenses (such as depreciation) - increase in receivables - increase in inventory + increase in payables
Suppose a company reports net income of $250,000 and depreciation of $80,000. During the year, receivables rise by $40,000, inventory rises by $25,000 and payables rise by $15,000. Operating cash flow = 250,000 + 80,000 - 40,000 - 25,000 + 15,000 = $280,000. The company earned $250,000 of profit but generated $280,000 of cash from operations.Case study
Seen in the real world
Pelham Furnishings is a fictional furniture retailer created for this illustration. Its income statement showed a net profit of $320,000, and the owners planned to take a $250,000 dividend.
The finance manager prepared the cash flow statement and found that operating cash flow was only $60,000, after adding back $40,000 of depreciation. Inventory had increased by $210,000 because of a large purchase before a planned promotion, and receivables from commercial customers had increased by $90,000.
The illustrative conclusion was that the business could not pay the dividend from operations without borrowing. The owners reduced it to $50,000, and the company started to track operating cash flow monthly alongside profit.
Watch out
Common mistakes
- Treating profit as cash, when working capital movements can create a large gap between the two.
- Adding back depreciation and thinking the company has generated extra money, when depreciation only reverses a non-cash cost.
- Ignoring operating cash flow in a growing business, when rapid growth often consumes cash through receivables and inventory.
Questions
People also ask
What is the difference between operating cash flow and free cash flow?
Operating cash flow is cash from the core business, while free cash flow subtracts capital spending to show what is available to investors and lenders.
Can operating cash flow be negative for a healthy company?
Yes, during fast growth or seasonal stock building, but it should not remain negative for long without a clear explanation and funding.
Where do I find it?
It is the first section of the cash flow statement, usually labelled net cash from operating activities.
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