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Comparing operating cash flow to net income also gives investors and lenders an idea if accounting techniques are manipulative. For instance, if a company reports high earnings, yet is low on cash, the accounting methods might be called into question, especially if this occurs over several quarters. No matter how the numbers are adjusted on the net income report, a company will eventually require sufficient cash in order to pay creditors, so such questionable practices will eventually emerge.
On the other end of the spectrum, if your operating cash flow is higher than your net income, that may mean your company has more cash than is reflected on the net income statement and is healthier than it looks on paper.
Operating cash flow is an accurate indicator of the health of your business. Do you know what your company’s numbers look like?
SEPTEMBER 26, 2013If there’s only one financial figure you keep on top of when it comes to your business, let it be operating cash flow. Operating cash flow offers a bird’s eye view of the economic state of your business and can potentially predict the future success or failure of your company.
Your cash flow figures will reveal if your business is healthy and can generate sufficient money to pay your bills, remain functional and grow, or if it’s in trouble and requires external financing to stay afloat. To avoid the risk of bankruptcy, your business’s operating cash inflow must exceed your cash outflow.
How To Calculate It
So how do you figure out your operating cash flow? Subtract your operating expenses from the money generated by your company’s normal business activities. The calculation starts with adding depreciation to your net income, then making adjustments for working capital like accounts receivable and inventory. Think of it as the cash portion of your net income. The operating cash flow number is recorded on your quarterly and annual cash flow statements.Operating Cash Flow Vs. Net Income
Investors and lenders prefer analyzing your operating cash flow as opposed to your net income, because it’s adjusted for depreciation, receivables and liabilities. Companies can potentially show positive net earnings yet be cash poor, unable to pay expenses and debt. For instance, a sales number can become inflated when inventory is sold but no cash comes in at that time. And if there were to be returns on the merchandise, no cash would ever come in for that inventory. The net income would show the inflated sales figure during that period, making the company look more profitable perhaps than it really is, while the operating cash flow figure would reveal the true picture.
Comparing operating cash flow to net income also gives investors and lenders an idea if accounting techniques are manipulative. For instance, if a company reports high earnings, yet is low on cash, the accounting methods might be called into question, especially if this occurs over several quarters. No matter how the numbers are adjusted on the net income report, a company will eventually require sufficient cash in order to pay creditors, so such questionable practices will eventually emerge.
On the other end of the spectrum, if your operating cash flow is higher than your net income, that may mean your company has more cash than is reflected on the net income statement and is healthier than it looks on paper.
The Benefits of Positive Operating Cash Flow
There are several advantages to a positive operating cash flow. Perhaps most important is your ability to pay your bills so you can continue to operate. A positive cash flow also enables you to withstand delays in payment from customers and weather setbacks like a client going out of business. A healthy operating cash flow also gives you the flexibility, and ability, to expand your business when you choose to do so. For instance, you can offer cash for a new piece of equipment and pay less than if you were to finance it. It also means you have a good chance of obtaining financing. When reviewing your application for credit, underwriters will take a close look at your company’s financial statements. A consistently positive operating cash flow will show them you’re a good candidate for credit, because you have the cash on hand to repay your debt. A freelancer since 1985, Julie Bawden-Davis has written for many publications, including Entrepreneur, Better Homes & Gardens and Family Circle. Read more articles and see exclusive videos in OPEN Forum’s special section on Managing Your Money. Read more articles on cash flow. Photos: Thinkstock, Getty Images [/vc_column_text][/vc_column][/vc_row]
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© Julie Bawden Davis