Cash flow from operating activities

By Sean Stevenson – Latest Revision January 3rd, 2021

What is Cash Flow From Operating Activities?

Cash flow from operating activities (or CFO) is the amount of money a company makes (or consumes) from its regular business activities over the course of a specified period of time.  

A simple example of this would be a car manufacturer that sold its vehicles to consumers.  The profits made from these transactions would represent the company’s cash flow from operating activities.

On a typical cash flow statement, the CFO is the first section depicted.  It provides immediate clarity about the core operations of a business enterprise and the typical amount of net profit it makes.

Cash flow from operating activities includes:

  • Generating revenue
  • Paying expenses

CFO does not include:

  • Long term capital expenditures
  • Investment revenue
  • Investment expenses

Key Takeaways

  • Cash flow from operating activities defines the success of core business operations using financial metrics
  • Using cash flow from operating activities as a financial metric, investors can understand how profitable a business is in its day-to-day ventures
  • Cash flow from operating activities is the first section presented on a company’s cash flow statement

The Importance of Cash Flow From Operating Activities (CFO)

Cash flow represents the most integral part of any healthy and profitable enterprise.  It represents a strong indicator for both a company’s present and future prospects.

A typical company will systematically analyze its own cash flow internally.  This helps management to make better financial decisions. They may also discover new ways to grow their existing enterprise.

A company’s cash flow characteristics are detailed in both quarterly and annual fiscal reports.  Publicly traded companies will have these available online, or by request.  In general, a company’s cash flow from operating activities will give good account of its primary income streams.  Any and all core business activities will be listed therein, allowing for further analysis and research.

The availability of capital (cash) is what allows a company to expand its efforts to generate further profit.  It represents a key advantage in the business world.  

An enterprise that enjoys a large reserve of capital will be able to launch new products, expand existing infrastructure, and conduct developmental research.  In essence, this is what allows it to grow. 

Whenever a company is able to reduce its debt or bolster shareholder confidence, it is effectively signaling its business acumen to prospective investors.  Moreover, dividends paid to investors, or a buy-back of outstanding shares, can further entice the marketplace if backed by strong indicators. 

Stock purchasers are always on the lookout for a company with a relatively lower share price backed with ever-increasing cash flows. Established operations such as this make for an enticing investment. 

Strong financial indicators can certainly give a sense of opportunity in the near or long term.  However, caution and due diligence is always advised.  The gains made must never be anomalous, nor inconsistent.  They must represent continual growth in core operational cash flows to represent a legitimate investment opportunity.

A company with consistently increasing cash flow that has remained positive over a longer period of time is representative of a prosperous enterprise.  This is a strong indicator that the core methods of the business are sound and producing high-quality earnings

Generic Cash Flow From Operating Activities Formula

This formula may vary based upon a company’s core activities, its balance statement, and income sheet.  There is a generic operations formula that may be used. 

To calculate the cash flow from operations, use this equation:

Net Income + Non-Cash Items + Changes in Working Capital = Cash Flow From Operations 

In using this equation, you can may get a sense of a company’s overall direction in terms of raw profits.  This will represent the success of its core business model and activities.

Understanding the Cash Flow Statement

The cash flow statement is required in standardized financial reporting.  It is made up of three distinct sections- cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. 

By analyzing these three depictions, we can understand how the company is making its core-profits.  Moreover, we can gain a clearer picture of how these profits are used to improve the existing enterprise.  The net change that represents the end financial results, also gives us an indication of exactly how profitable the business is.

In the cash flow from investing section, we can see the cash that is devoted to purchasing new assets.  Whether for a fixed or longer-term approach, the company’s financing metrics will be clearly laid out.  Should any sale of an asset occur, the proceeds would also be listed herein. 

The cash flow from financing section depicts the sources of a company’s capital and financing.  Alongside this, is payment and servicing of loans.  A good example of items that would fall under such capital and financing, would be the issuance of dividend payments, bonds, and stocks.  Also, any payments of interest would also be included for review.

Example

Below is a cash flow statement, taken for reference.  This represents the cash from operations, cash invested, and cash from financing respectively.  Understanding each section will give insights into the core financials of a business model.  It will also tell us if the cash flow balance is currently positive or negative.

Cash flow from operating activities

Key Takeaways

  • In a financial report, the cash flow from operating activities can be found within the cash flow statement section
  • In essence, investors use a company’s cash flow from operating activities to understand a company’s profit-taking situation (i.e: where the money is coming from)
  • An important distinction between core operating activities compared to financing and investing activities, is that the operating activities are recurring, whereas investments may be sporadic at best
  • The best way to judge any investment opportunity is to understand its recurring cash flow from core business activities

Pro Tip:  The three main financial statements required for publicly listed companies (and standard accounting) are:

  1. The cash flow statement
  2. The income statement
  3. The balance sheet

Methods of Cash Flow From Operating Activities

A cash flow statement will depict the cash from operating activities either using the direct method, or the indirect method.  Both of these methods represent a distinct financial accounting procedure:

The Indirect Method

Using this method, the company’s net income is met with an accrual of revenue that is recognized when earned.  An accountant works backwards to achieve a cash figure for profits within a specified period.

Example

A customer purchases a $30,000 car, using limited-time bargain financing.  While the cash has not been received, the revenue amount is still recognized as net income in the month in which it was sold.

In actualizing the basis of the cashflow, the $30,000 amount would appear under accounts receivable in the company’s balance sheet.  Moreover, on the cash flow statement, it would be represented by a reduction in the amount still outstanding.  To represent this, it would appear as “Increase in Accounts Receivable -$30,000.”

The Direct Method

This methodology tracks actual cash inflows and outflows.  It uses all listed transactions within the cash flow statement over a specified accounting period.  Some examples of the direct methodology of cash flows from operating activities are:

  • Interest or dividends received
  • Salaries paid to employees
  • Cash paid to suppliers or vendors
  • Income tax and interest paid
  • Cash received from customers

Example

The outflow of cash paid to suppliers was tracked in the first quarter.  This will appear within the cash flow statement for future reference.

Direct Vs. Indirect Methods of CFO

It is recommended by the FASB (Financial Accounting Standards Board) that the direct method be used for accounting purposes.  This is due to the direct method offering a more definitive analysis of cash flows as they exist within a business.

Despite this recommendation, many accountants still prefer the use of the indirect methodology.  This is because of its relative simplicity in preparing a detailed cash flow statement using information from the balance sheet and income statement.

Most companies today base their accounting practices on the accrual method.  This means that the income statement and balance sheet will have figures consistent with the indirect methodology, making it an easy choice for accounting purposes.

CFO As It Relates To Capital Expenditure

It is important to note that operating cash flow does not take into account any capital investments whatsoever. 

Regardless if the business requires the influx of such capitalization to grow or sustain the business as an ongoing concern, it will not be a part of a company’s CFO in any standardized accounting practice.

Additional Considerations

The following are commonly reflected in cash flow from operations, where a perceivable change in valuation is to be reflected in a financial statement:

  • Tax assets
  • Inventories of any kind
  • Account receivable
  • Accrued revenue

The following are commonly noted liabilities.  Whereby a change in valuation is to be depicted in the cash flow from operations:

  • Tax liabilities
  • Accounts payable
  • Accrued expenses
  • Deferred revenue

When using the indirect method, it is important to understand its forward-looking properties.  For example, an increase in accounts receivable, would indicate that a payment has not yet been received (but is pending from the customer).  Conversely, an increase in a liability within accounts payable, would indicate that an expense has not yet been paid.  Yet this expense is expected to be honored by the business.

The purpose of this forward-looking projection of cash flows is to offer a means of calculation.  Naturally, this method is not always precise.  Though it does offer a clear depiction of the overall expected returns and expenditures.

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