Business owners looking to take control of their finances and bookkeeping need to have a robust understanding of their profit and cash flow. These are fairly rudimentary terms, but they play a significant role in a company's health and overall lifespan.
- Net income refers to the profit a business earns over a specific period of time.
- Operating Cash flow is a measurement of operating activities (i.e., what comes in and out daily).
While these two components are inheriting connected, their calculation does present different value to a business owner. Knowing how to take advantage of this data can help you make crucial decisions — helping you achieve your goals.
In this article, we're going to cover the basics and give you the inside scoop as to how you can calculate both net income and operating cash flow and use them for your business.
The Scoop on Net Income
Net income is a vital metric of your business's profitability. To gain access to this data, all you need is a simple calculation.
All you need to do is subtract the cost of operating expenses, sales, depreciation, interest, amortization, and taxes from your total business revenue. This is a key component of your profit and loss statement (along with expenses and revenue).
Net Income = Costs - Total Revenue
So, let's go over an example.
Company A.
Total Revenue = $1.5 million
Costs:
- Manufacturing expenses = $20,000
- Product purchases = $450,000
- Depreciation = $9,000
- Administrative expenses = $70,000
- Taxes = $315,000
Net Income = $636,000
Now, this is a very basic version of an "income statement," which will likely have many more costs and deductions attached. However, the formula remains the same — you subtract all costs from your overall revenue to calculate net income.
Operating Cash Flow
Operating cash flow, also known as OCF, is a component of cash flow statements. We have actually covered this in-depth before, so if you are interested in learning more about OCF, check our guide to the OCF formula.
A CFS (cash flow statement) is an indicator of how a company manages its cash, which will showcase how equipped it is to pay off debt obligations and fund day-to-day operations. Both cash inflows and outflows are a part of operating cash flow during a period of time, and include:
- Receipts from sales of goods (or services)
- Payroll and other expenses
- Payments to suppliers
- Rent
- Taxes
There is a lot of information to be found in operating cash flow that can help a business owner better understand their company's health. For instance, increases in accounts receivable, inventories, and deferred revenue are uses of cash. Decreases in liabilities like accounts payable, accrued expenses, or tax liabilities are considered uses of cash as well. These can be used to pay off debt financing or other loans obtained during the business.
Operating cash flow does not include the use of cash for long-term investments or capital expenditures. Additionally, they do not include cash inflows that come from a sale of a long-term asset. Also excluded are dividends to stockholders or cash received from the issuance of stock and bonds.
So, how do we calculate? It's actually quite simple.
Operating Cash Flow = Operating Income + Depreciation - Taxes + Changes in Working Capital.
Let's see it in practice with the indirect method.
Company B.
Operating Income = 1.5 Million
- Depreciation Expense = $2 million
- Increase in accounts recievable = $500,000
- Decrease in acounts payable = $500,000
- Taxes = $315,000
Operating Cash Flow = $2,185,000
Comparing These Formulas
When we look at net income vs. operating cash flow, there's a lot to digest. Yes, these two calculations showcase different aspects of the business's finances — but they also treat certain items drastically differently.
While non-cash expenses like depreciation and amortization need to be included in net income, they don't necessarily reflect the cash flow of a company. So, these expenses end up getting added back to a cash flow statement.
If you're looking for an answer as to what is most important, the answer isn't necessarily that simple. The overall goal of a company is to boost net income. However, your operating cash flow will give a much more targeted understanding of your financial health over time.
If you're looking for fast debt financing, having cash on hand is crucial. This can ensure that you're able to meet debt obligations, create opportunities for growth, and issue dividends when necessary. The truth is that healthy operating cash flow over extended periods of time will create a steady net income.
Other Financial Considerations
In addition to net income and operating cash flow, you'll need to have a firm grasp on a wide range of calculations for business finances. These include understanding the differences between gross profit and gross profit margins along with working capital.
Calculating working capital is critical for maintaining everyday business expenses and navigating your business towards profit. Speaking of profit, there is a distinction between profitability and profit that should be taken into account.
If you're interested in learning more about these business financial "must knows," click the links above to gain helpful insights for your company.
Wrapping Up
Understanding how to leverage net income and operating cash flow for your business is essential. For startup entrepreneurs or small business owners, these are crucial aspects of your enterprise. Many of the components we covered here are integrated into some of the best business accounting software on the market — which will make your life a lot easier when it comes to calculating.
So, to wrap things up, here are some takeaways from today's article:
- Net income is a major driver of stock and bond valuations
- OCF excludes non-cash items like depreciation and amortization (as these can misrepresent the genuine financial position of a company)
- The more OCF, the better the cash flow for debt financing
- Net income is your bottom line profitability, as even positive OCF can lead to negative net income if it goes unchecked
