How to calculate operating cash flow
Learn how to calculate operating cash flow using the direct and indirect methods. Get step-by-step instructions, examples, and best practices.
If you’re managing a business or overseeing its finances, operating cash flow, or OCF for short, is one of the most important metrics you should be tracking. It tells you whether your business is turning a profit: generating enough cash from its day-to-day core activities to sustain itself without relying on funding.
This is the metric you need to focus on to accurately evaluate how much money your business earns from your typical operations. . Understanding how to calculate operating cash flow using both the direct and indirect methods is the foundation to stable organizational financial health.
What is operating cash flow and why is it important?
Operating cash flow (OCF) is the cash your business generates through everyday activities, calculated by subtracting your operating expenses from your revenue. It indicates whether a company can generate enough income to maintain and grow operations, and it doesn’t include investments or interest on cash holdings.
OCF matters because it indicates how self-sustaining your business is over time, based on your normal business operations (not investments, financing, or other external funding)..
It is the primary tool for determining creditworthiness, since a consistently positive and increasing OCF suggests operational sustainability while a negative one typically indicates the opposite.
So, how do you calculate your operating cash flow?
There are two standard ways to calculate OCF — direct and indirect.
Both methods will give you the same bottom-line figure, but they take different paths to get there.
The direct method collects and sums up all actual cash transactions, from receipts and payments related to operations, to offer a complete view of cash movements. The indirect calculation method starts with your net income (from the income statement) and gradually adds non-cash items and changes in working capital to arrive at the complete view from another angle.
Direct method
The direct method tracks all transactions on a cash basis, showing you the actual cash inflows and outflows over a specific period. It requires detailed recordkeeping and correct segmentation of each line item to pinpoint all cash transactions related to the reporting period. The Financial Accounting Standards Board (FASB) prefers this approach, and it’s more common for small businesses because it’s difficult to scale.
Cash revenue
This isn’t your full revenue figure — it’s only the cash you actually received from customers during the period. Credit sales don’t count unless the money went into your account. Payments from accounts receiveable, like old invoices that were finally paid, are also included here.
Accurate tracking requires reconciliation with accounts receivable and sales records to isolate actual cash inflows.
Cash payments for operating expenses
Represents the cash that physically left your accounts to cover operating costs like wages, contractor payments, materials, utilities, rent, and other day-to-day business expenses. If you recorded an expense but haven’t paid it yet, it doesn’t belong here.
This often means pulling from the cash disbursement journals or bank feeds, rather than relying only on GL balances.
Cash payments for interest and taxes
Under U.S. GAAP (generally accepted accounting principles), interest on loans and income tax payments are categorized under operating activities. If you’ve accrued a tax liability but haven’t paid it yet, the expense might appear on your P&L. But until you actually make a payment, there’s no impact on operating cash flow.
Cash payments for inventory
This line only includes purchases of inventory items that were paid during the reporting period. Doesn’t matter when you placed the order — if it wasn’t paid, it’s not included.
Indirect method
The indirect method is kind of like reverse-engineering your cash flow. Instead of listing every cash transaction, you start with your net income — aka your “profit on paper” — and then strip out all the non-cash items. From there, you adjust for changes in working capital to get to your actual cash situation. This approach is more common at large companies where going through every line item isn’t feasible.
Net income
This is your bottom-line profit, straight from the income statement (calculated using GAAP). It includes revenue earned and expenses spent, whether or not they’ve been paid.
Adjustments for non-cash items
Depreciation, amortization (spreading the cost of an asset over time), and other non-cash charges that reduce net income but didn’t affect cash in the current period are added back in.
Adjustments for working capital changes
You adjust for shifts in accounts receivable, accounts payable, inventory, and other short-term accounts that impact cash.
An increase in AR represents cash outflow, and a decrease in cash inflow, as customers owe you money. An increase in AP or accrued expenses indicates a deferral of cash inflow, as you owe more to suppliers and vendors.
Simply put:
- If accounts receivable went up, that’s cash not collected — subtract it.
- If inventory went up, you spent cash stocking up — subtract that too.
- If accounts payable went up, that’s cash that has not been spent yet and should be added back.
Adjustments for other operating activities
“Shelved” tax liabilities, prepaid expenses, and/or non-operating gains or losses (like asset sales) are also included or excluded based on their impact on actual cash generation.
Example calculation of operating cash flow
Let’s run through a quick scenario to see both methods in action. The following example demonstrates how to find operating cash flow using both the direct and indirect methods and how to calculate cash flow from operations.
Hypothetical income statement and balance sheet
An income statement for a small business — for example, a boutique bakery — shows $500K in revenue, primarily from cake sales and catering services. The cost of goods sold (COGS) is $300K, covering ingredients, packaging, and kitchen staff wages. Operating expenses total $100K, including rent, utilities, and marketing.
Of the $100K in operating expenses, $20K is non-cash depreciation on baking equipment, and $7K is an increase in accrued expenses that haven’t been paid yet (such as utilities or unpaid marketing invoices). This results in an operating income of $100K.
Applying a 25% tax rate yields $25K in tax expenses, producing a net income of $75K.
On the balance sheet, year-over-year changes in working capital include:
- Accounts receivable increased by $10,000
- Inventory increased by $5,000
- Accounts payable increased by $8,000
- Accrued expenses increased by $7,000
Direct Method Calculation (for a Boutique Bakery)
The bakery generated $500K in revenue, but accounts receivable increased by $10K, meaning only $490K was actually collected in cash from customers.
To calculate cash paid to suppliers, we start with the $300K cost of goods sold (ingredients, packaging, staff labor), adjust for the $5K increase in inventory (more raw materials purchased), and subtract the $8K increase in accounts payable (amounts not yet paid to suppliers):
$300K + $5K – $8K = $297K paid in cash to suppliers
Operating expenses include $100K total, but $20K is non-cash depreciation and $7K is accrued but unpaid, leaving a cash expense of $73K.
Assuming a 25% tax rate on the $100K operating income (EBIT), taxes paid in cash = $25K.
Total cash outflows:
- $297K to suppliers
- $73K in cash operating expenses
- $25K in tax payments
= $395K total
Subtracting this from the $490K cash received from customers, we get an operating cash flow of $95K.
Indirect Method Calculation
We begin with net income of $75K.
- Add back $20K in depreciation (non-cash)
- Add $7K increase in accrued liabilities (a source of cash)
- Subtract $10K increase in accounts receivable (use of cash)
- Subtract $5K increase in inventory (use of cash)
- Add $8K increase in accounts payable (source of cash)
$75K + $20K + $7K – $10K – $5K + $8K = $95K operating cash flow
Comparison of results
Both methods calculated OCF as $95K in this example, and since both methods are simply different ways of calculating the same figure, that’s as it should be. If you calculate both and arrive at different numbers, this is likely due to errors, misclassified items, or incomplete adjustments, particularly in the indirect method where working capital movements and non-cash items must be correctly identified.
You should cross-check and compare results to validate the accuracy of the underlying data or highlight inconsistencies.
Best practices for calculating operating cash flow
Here’s how to keep your operating cash flow numbers clean, useful, and ready to back up your business decisions:
- Track every dollar—maintain accurate records of all the cash moving in and out of your business, not just what’s on your income statement.
- Always reconcile income statement items with real bank transactions—accrual accounting is great, but it doesn’t tell you where your cash actually is. Reconcile income statement items with cash movement regularly to ensure consistent reporting.
- Automate what you can—use accounting software that tracks working capital changes in real time. It’ll save you a ton of manual cleanup.
- Double-check non-cash entries—before running the indirect method, make sure things like depreciation and amortization are accurate. It’s easy to miss adjustments that throw off your final OCF.
- Use both methods—analyze both direct and indirect methods periodically to cross-check operational efficiency and liquidity. If the numbers don’t line up, something’s off.
- Keep investing and financing out of it—exclude cash flows related to financing (loan repayments, dividends) and investing (asset purchases, interest) to avoid overstating OCF.
Summary
Operating cash flow gives you the clearest look at whether your business is actually working, day in and day out.
Melio is here to simplify the process. We offer a suite of tools designed to enhance your cash flow management, including scheduled payments to maintain optimal cash reserves, credit card payments to defer cash outflows, real-time payment tracking for accurate forecasting, and accounts receivable management to accelerate incoming payments. By integrating Melio into your financial operations, you can gain better control over your cash flow, and ensure your business remains resilient and well-positioned for future opportunities.
