What is cash flow from operations and how do you calculate it?

What is cash flow from operations?

If you look at a cash flow statement, you’ll see operating cash flow in the first section.

Cash flow from operations is the money that’s earned and spent through your normal business activities. You might also see it referred to as operating cash flow (OCF) and cash flow operations (CFO) – they both mean the same thing.

Operating cash flow (OCF) shows how money moves in and out of your business without taking investments or financing into account. It focuses on sales and day-to-day expenses instead.

Normal business operating activities can include:

• revenue (for goods and services, depending on what kind of business you have)
• royalties
• interest and dividends
• supplier bills
• pay for employees, freelancers, and contractors
• rent
• utility bills

Calculating your cash flow from operations can help you understand the financial health of your business. Operating cash flow tells you if you have enough money to pay suppliers and bills and if the products or skills you provide can sustain your business income.

Understanding the role and importance of cash flow from operations

Cash flow from operations focuses on your core business activities – the stuff you do every day to keep your business running. Knowing your cash flow from operating activities lets you see how profitable (or not) your business is. It’s a stripped-back view of how your business runs.

Sometimes, businesses rely on financing and loans to stay afloat. Both of these areas are included on a standard cash flow statement, to give a complete picture. But if you calculate cash flow with these two factors included, it skews your view of your profitability.

Say you run a floristry business and your operating cash flow for this month is £2,000. You also receive a one-off £3,000 small business grant. Combined, your cash flow this month is £5,000.

The £5,000 figure makes your business look more profitable than it is. The money you’ve earned from your core business – selling flowers – is much lower, at £2,000.

If you want to make big financial decisions or anticipate cash flow problems, operating cash flow is a key indicator of what you can afford. Calculating this regularly will help you manage your finances and cash flow.

Understanding the components of cash flow from operations

To perform a cash flow calculation, you need to know a few financial terms:

• Net income: You’ll find net income at the bottom of your income statement. It’s your total profit, minus all expenditures (including non-cash expenses like depreciation and deferred taxes). Read this net income calculation guide for more information.
• Non-cash items: These affect your profitability on paper, but don’t involve cash changing hands. For example, a piece of equipment might have lost value, but that doesn’t mean you’ve physically lost cash.
• Changes in working capital: This is the difference between your current assets (accounts receivable, money owed by customers, inventory, cash) and current liabilities (accounts payable, bills due soon, short-term debts). It’s the money you have available once all assets and liabilities are accounted for.

A cash flow from operations formula will combine these components to tell you how much operating cash flow you have.

How to calculate cash flow from operations – a step-by-step guide

There’s more than one way to calculate cash flow from operating activities. Let’s look at the direct and indirect methods.

Indirect method

This starts with your net income which you can find on your income statement for the relevant period. Add back any non-cash expenses to your net income like depreciation of equipment – because these types of losses don’t impact your operating cash flow. Then, adjust your net income figure for working capital changes.

Here’s the formula:

OCF = net income + non-cash expenses + changes in working capital

Direct method

Alternatively, the direct method starts with your income and expenditure. You need to tally up everything spent and earned as part of your usual business operating activities (all cash inflows and outflows), then subtract expenditure from income.

Here’s the formula:

OCF = total cash inflows - total cash outflows

Both direct and indirect methods should give you the same result. They’re just different ways of approaching the calculation. The direct method provides a more detailed breakdown of cash transactions, but you might find the indirect method easier to apply using your financial statement data.

Want to save time? Smart accounting software can take care of cash flow from operations calculations for you. Xero uses your real-time bookkeeping data to generate accurate, reliable reports and provide a clear view of your operating cash flow. We also have a cash flow calculator to help you crunch the numbers.

Example of cash flow from operations

Let’s use the indirect method formula.

Sweet Tooth Dental reported a net income of £40,000 for the last financial year. They had £4,000 in non-cash expenses due to the depreciation of medical machinery. Throughout the year, there were some changes in working capital:

Current assets increased by £2,000 because some patients bought on credit despite not settling not their bills yet. And inventory increased by £1,000, as they purchased new surgical kits and protective equipment.

Current liabilities increased by £1,000, as they postponed paying some suppliers.

Using the indirect method, Sweet Tooth Dental’s operating cash flow calculation looks like this:

OCF = £40,000 + £4,000 + (£3000 - £1,000)

Operating cash flow = net income + non-cash items + working capital changes (current assets - current liabilities)

The cash flow calculation shows Sweet Tooth Dental has an OCF of £46,000. This means Sweet Tooth Dental generated £46,000 from its dentistry operations in the previous financial year.

How to improve cash flow from operations: Strategies and tips for success

Improving cash flow from operations can give you some financial breathing room. If you have more available cash, you don’t need to worry about paying the next bill or dealing with an emergency. Instead of being reactive with your money, you can be proactive – and invest in the growth of your business.

Here are some ideas for how to improve cash flow from operations:

1. Encourage faster invoice payments: Cash tied up in unpaid invoices limits your spending power. Make sure your invoices are sent on time, easily paid, and followed up if customers are late paying. If you’re using Xero, you can add payment providers such as Stripe and GoCardless to give your customers more ways to pay.
2. Manage supplier payments more efficiently: There may be a better time to pay your suppliers based on your operating cash flow. Make sure you notify suppliers before delaying your payment schedule. And always pay on time to protect relationships and avoid late payment fees.
3. Reduce inventory: If your cash is tied up in stock, it’s less readily available should you need it for something else. Create an inventory report to see what you’re selling each month and base your stock levels on this data.
4. Limit expenditure: Expenses eat into your available cash flow. Try to focus your spending on the essentials, and regularly monitor what moves out of your account. Do away with the unused subscriptions and charges that can easily go unnoticed.
5. Check your cash position regularly: Your cash flow position isn’t fixed – it changes every time you get paid or make a purchase. Producing a cash flow statement regularly can help you understand all aspects contributing to your business’s financial health. That kind of clarity lets you make better-informed financial decisions.
6. Project your cash position regularly, too: A cash flow statement is great for the here and now, but ideally you want to understand what’s up ahead. That's where cash flow forecasts come in, and they’re easily created using cloud-based accounting software.

Streamline your cash flow with Xero

Xero accounting software can give you a clear view of all types of cash flow – so you have the tools and knowledge to make smart financial decisions. Produce cash flow forecasts and statements that are simple to read and take action on.

For more on managing your business finances, head to our cash flow content hub.