Operating Cash Flow vs. Free Cash Flow: The Guide for Small Businesses

As a small business owner, managing cash flow is crucial to your success. However, understanding the different types of cash flow that your business generates can be confusing. Operating cash flow and free cash flow are two important metrics that every business owner should know. In this guide, we will explain the difference between operating cash flow and free cash flow and why understanding these concepts is essential for the growth of your business.

What is Operating Cash Flow?

Operating cash flow (OCF) is the amount of cash generated by a company’s operating activities, such as sales, revenue, and expenses. In other words, it shows the amount of cash that a business has on hand to cover its day-to-day operations. A positive operating cash flow indicates that a business is generating enough cash to cover its operating expenses, while a negative operating cash flow indicates that a business is spending more cash than it is generating from its operations.

Related Reading: Strategic Ways to Increase Your Revenue

Positive vs. Negative Operating Cash Flow Defined

There are two types of operating cash flow:

Positive Operating Cash Flow

This refers to a situation where a company generates more cash from its operations than it spends. A positive operating cash flow is generally seen as a good sign as it means the company has enough cash on hand to pay its bills, invest in new projects, and pay dividends to shareholders.

Negative Operating Cash Flow

This refers to a situation where a company spends more cash on its operations than it generates. A negative operating cash flow can be a cause for concern as it may indicate that the company is not generating enough revenue or is overspending on its operations. In such cases, the company may need to raise additional capital through debt or equity financing to cover its expenses and invest in future growth opportunities.

Both positive and negative operating cash flows are important metrics for investors and analysts as they provide insights into a company's liquidity, cash flow management, and ability to generate sustainable profits over the long term.

How to Calculate Your Operating Cash Flow

There are two main methods for calculating operating cash flow:

1. Direct Method: Operating Cash Flow = Total Revenue - Operating Expenses
2. Indirect Method: Operating Cash Flow = Net Income + Depreciation/Amortization + Non-cash Items +/- Changes in Working Capital

Typically, the indirect method is the more widely-used of the two methods as it is easier to apply in practice and can be derived from a company's income statement.

What is Free Cash Flow?

Free Cash Flow (FCF) is the amount of cash that a company generates after taking into account its capital expenditures. In other words, it shows the amount of cash that a business has available to pay off debt, buy back shares, or invest in new opportunities.

Capital expenditures refer to the money that a company spends on investments in property, plant, and equipment (PP&E). A positive free cash flow indicates that a business has enough cash to reinvest in the business, while a negative free cash flow indicates that a business may need to borrow money or raise capital to fund its growth.

Related Reading: Top Business Loans for Small Business Owners

Types of Free Cash Flow

The two main types of free cash flow are:

Free Cash Flow to Equity (FCFE)

This type of free cash flow measures the amount of cash available to a company's equity holders after all expenses and reinvestments have been made. FCFE is often used by investors as an indicator of a company's ability to generate cash and pay dividends to its shareholders.

Free Cash Flow to Firm (FCFF)

This type of free cash flow measures the amount of cash available to a company's debt and equity holders after all expenses and reinvestments have been made. FCFF is often used by analysts to evaluate a company's ability to pay off its debt, invest in new projects, and pay dividends to its shareholders.

Both types of free cash flow are important metrics for investors and analysts as they provide valuable insights into a company's financial health and future growth potential.

How to Calculate Your Free Cash Flow

There are two main methods for calculating free cash flow:

1. Free Cash Flow to Equity (FCFE) = Net Income - Capital Expenditures + Net Borrowing
2. Free Cash Flow to Firm (FCFF) = Net Income + Non-Cash Expenses - Changes in Working Capital - Capital Expenditures

The FCFE equation calculates how much cash is available to the company's equity holders, while the FCFF equation calculates how much cash is available to both debt and equity holders.

Tips for Improving Your Cash Flow

Here are some tips for improving cash flow if you're in the negative:

1. Increase Sales: One of the most effective ways to improve operating cash flow is to increase sales revenue. This can be achieved by expanding your customer base, introducing new products or services, or increasing marketing efforts.
2. Manage Inventory Carefully: Excess inventory ties up valuable cash and can negatively impact operating cash flow. To improve cash flow, it's important to manage inventory carefully by forecasting demand, optimizing order quantities, and reducing lead times.
3. Cut Costs: Reducing expenses is another effective way to improve operating cash flow. This can be achieved by negotiating better terms with suppliers, implementing cost-saving measures, and eliminating unnecessary expenses.
4. Improve Collections: Delayed payments from customers can hurt cash flow. To improve collections, consider offering discounts for early payments, sending reminders for overdue payments, and following up with customers regularly to ensure timely payments.
5. Manage Debt Wisely: High levels of debt can negatively impact operating cash flow, especially if interest payments are high. To manage debt wisely, consider refinancing high-interest debt, negotiating better payment terms with creditors, and avoiding taking on additional debt unless absolutely necessary.

By implementing these tips, companies can improve their cash flow and position themselves for long-term success.

Why Should Small Business Owners Know the Difference?

Understanding the difference between operating cash flow and free cash flow is vital for small business owners, as it helps them identify areas where they need to improve their finances. By analyzing their OCF and FCF, business owners can determine the liquidity of their business and its ability to generate enough cash to sustain and grow the business.

Small business owners must focus on generating positive operating cash flow since it is the lifeblood of the business and should be enough to cover all operating expenses. On the other hand, positive free cash flow can provide flexibility for growth opportunities or for dealing with unexpected expenses.

Manage Your Small Business Finances Effectively

Operating cash flow and free cash flow are two important metrics that every small business owner should understand. Operating cash flow measures a business’s ability to generate cash from its core operations, while free cash flow shows the cash a business has available after capital expenditures.

By analyzing these metrics, small business owners can identify opportunities to improve their finances and ensure that their business has the liquidity to sustain long-term growth and stability. Understanding OCF and FCF can assist business owners in making critical decisions that should set their business on a path to success. Subscribe to our newsletter to stay updated on the latest business finance trends.