Cash flow from Operations | Examples | Formula

amazon-cash-flow-from-operations

source: ycharts

Cash flow from Operations – One of the most important component of any cash flow statement is ‘cash flow from operating activities’. In this article we will look at this in detail and understand why it is such an important pillar of the cash flow statements. Investors can find many important details and section and the fine print analysis of the same can help in making informed decisions.

This article on Cash Flow from Operations is structured in the following order –

What is Cash flow from Operations?


‘Cash flow from operations’ tries to look into the cash inflows and outflows caused by the core business operations and in turn looking into the cash generated by the company’s products and services. The main component which are reflected in this part of the statement shows the changes made in cash, accounts receivables, inventory, depreciation and accounts payable segment. Analysts community look into this section with hawk eye as it shows the viability of the business conducted by the company.

In the long run, if the company have to remain solvent at net levels ‘cash flow from operations’ need to remain net positive (or in other words operations must generate positive cash inflows).

In a single line, we can say that cash flow from operating activities converts the items reported in the income statement from the accrual basis of accounting to cash.

It is always easier to understand when we create some questions and then answer them. So here are few questions which when answered would help us in understanding the topic in an easier manner.

  1. When any company purchases inventory, what happens to the cash account of the company?
  2. What happens to the cash account of the company when any company borrows money from any bank by signing a note payable?
  3. What happens to the cash account of the company when a company pays some of its accounts payable?

Answer to Question 1: The cash account, in this case, would decrease, as the company would need to pay some cash for the purchased inventory. The double entry system of accounting would lead to increase in the asset account. In this case asset under consideration is inventory.

Answer to Question 2: In this case, cash account would increase as company has borrowed cash from the bank. Due to the double entry system, the liability account increases by the similar amount. The liability account under consideration here is Notes payable.

Answer to Question 3: In this case, the cash account would decrease as there is a cash outflow involved while paying the accounts payable. Due to the double entry system, the liability account would decrease by the same amount. The liability account under consideration here is Accounts payable.

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Preparation of Cash Flow from Operating Activities


Let us have a look at how this section of the cash flow statement is prepared. Understanding the preparation method will help us evaluate what all and where all to look into, so that one can read the fine prints in this section.

The beginning point of this section is net income figure which is available from the income statement of the company. If all of the company’s revenue was in the form of cash and there are no non-cash expense, then this remains as the main figure. However since in reality, it is not true, hence the non-cash charges and credit sales in the year need to be adjusted. Let us understand this by means of a hypothetical example.

Let us assume that Mr. X starts a new business and has planned that at the end of the month he will prepare his financial statements like income statement, balance sheet and cash flow statement.

1st month: There was no revenue in the first month and no such operating expense hence income statement will result in net income to be zero. In cash flow from operation, the starting point would be net income which will be zero, however, there is a decrease in cash by 700 dollars as the company decided to purchase some inventory.

Cash from Operating activities (for the first month)
Net Income  $            –
Increase in inventory  $ -700.00
Cash Provided (used) in operating activities  $ -700.00


2nd Month
: During this month company was able to sell 10 product units priced at 80 dollars each. The delivery of the product was done on 20th of the month and the buyer was provided an invoice worth 800 dollars due by 10th of the next month. The cost of this product sold is 500 dollars. Hence as per income statement, the net income was $300 for the second month.

Cash from Operating activities (for the second month)
Net Income  $        300.00
Increase in accounts receivables  $      -800.00
Decrease in inventory  $        500.00
Cash Provided (used) in operating activities  $                 –

Please note that above cash flow from operating activities is just for the second month, the cumulative cash flow for two months would look like the one shown in the table below.

Cash from Operating activities (end of second month)
Net Income  $        300.00
Increase in accounts receivables  $      -800.00
Increase in inventory  $      -200.00
Cash Provided (used) in operating activities  $      -700.00


Understanding this cumulative two-month statement:
The net income for the two months of operation of the company has been 300 dollars. Since the amount is still not received by the company, it lies under accounts receivables (-800 dollars). During the two months’ inventory has increased by 200 dollars, hence shown as negative in the cumulative statement. As a result, the cash flows for the two-month period shows that Mr. X’s cash from operating activities is a negative $700. So in simple terms company has brought goods and paid for it, hence cash outflow took place. The company was able to sell the goods but money is still not received and hence company at cumulative level is standing negative on cash flow from operating activities.

3rd Month: This is the month in which the quarter ends for the company. The company purchased office equipment at the start of the month for 1100 dollars (accounted under cash flow from operating activities). Due to the purchase of the office equipment company also incurred non-cash depreciation charge of 20 dollars during the month.

Cash from Operating activities (for the third month)
Net Income  $                 –
Depreciation charge added back  $          20.00
Cash Provided (used) in operating activities  $          20.00

Please note that above cash flow from operating activities is just for the third month, the cumulative cash flow for the quarter would look like the one shown in the table below.

Cash from Operating activities (end of quarter)
Net Income  $        300.00
Depreciation charge added back  $          20.00
Increase in accounts receivables  $                 –
Decrease in inventory  $      -200.00
Cash Provided (used) in operating activities  $        120.00


Understanding this cumulative quarter statement:
The net income for the quarter of operation of the company has been 300 dollars. During the three months’ inventory has increased by 200 dollars, hence shown as negative in the cumulative statement. There is a depreciation charge of 20 dollars which is added back. As a result, the cash flows for the three-month period shows that Mr. X’s cash from operating activities is a $120.

Cash Flow from Operations – Direct Method


Cash flow from Operations using direct method includes determining all types of cash transactions including cash receipts, cash payments, cash expenses, cash interest and taxes.

Steps to calculate cash flow from operations using direct method is given below –

A) Cash Receipt: Represents the actual amount of cash received during the period

cash-receipt-cash-flow-from-operations

B) Cash Payment: Represents the actual amount of cash payments to the suppliers

cash-payment-cash-flow-from-operations

C) Cash expenses may include selling, administration, R&D and changes in other operating liabilities

D) Cash interest only recognizes interest expense paid in cash

cash-interest-cash-flow-from-operations

E) Cash Tax: Represents only taxes paid in cash

cash-taxes-cash-flow-from-operations

Cash Flow from Operations using Direct Method Formula = Cash Receipts – Cash Payments – Cash Expenses – Cash Interest – Cash Taxes

Cash Flow from Operations – Direct Method Example


ABC Corporation’s income statement sales was $650,000; gross profit of $350,000; selling and administrative costs of $140,000; and income taxes of $40,000. The selling and administrative expenses included $14,500 for depreciation.

Calculate the  Cash Flow from Operations using Direct Method. 

The following additional information is available

cash-flow-from-operations-direct-method-example

Cash Receipt = $650,000 – ($81,000 – $65000) = $634,000

Cash Payment = $300,000 – ($55,000 – $42,000) – (45,000 – $38,000) = $280,000

Cash Expense = $140,000 – $14,500 = $125,500

Cash Taxes = $40,000

Cash Flow from Operations using Direct Method =

$634,000 – $320,000 – $125,500 – $40,000 = $188,500

Cash Flow from Operations – Indirect Method


Cash flow from operations using indirect method starts with the Net income and adjust it as per the changes in the balance sheet.

Steps to calculate cash flow from operations using indirect method is given below

Step 1:
  • Start with Net Income
Step 2:
  • Subtract: Identify gains or losses that result from financing and investments (like gains from sale of land)
Step 3:
  • Add: Non-cash charges to income (such as depreciation and goodwill amortization) and subtract all non-cash revenue components
Step 4:
  • Add or subtract changes to operating accounts
  • Operating Assets: Increase in the balances of operating assets is subtracted while decrease in those accounts is added
  • Operating Liabilities: Increases in the balances of operating liability accounts are added, while decreases are subtracted

Cash Flow from Operations Indirect method Formula = Net Income + Gains & Losses from financing & investments + Non-cash charges + changes in operating accounts

Cash Flow from Operations – Indirect Method Example


Let us work through the same example we used for Cash Flow from Operations using Direct Approach.

ABC Corporation’s income statement sales was $650,000; gross profit of $350,000; selling and administrative costs of $140,000; and income taxes of $40,000. The selling and administrative expenses included $14,500 for depreciation.

Calculate the  Cash Flow from Operations using Indirect Method 

The following additional information is available

cash-flow-from-operations-direct-method-example

Since we are not provided with the Income Statement, let us quickly prepare an Income statement for above.

cash-flow-from-operations-indirect-method

Step 1: Net Income us $170,000

Step 2:  There are no gains or losses from financing and investments = $0

Step 3: Add depreciation (non-cash item) of $14,500

Step 4: Add or subtract changes to operating accounts

  • Cash outflow due to changes in Accounts Receivable = 65,000 – 81,000 = -16,000
  • Cash inflow due to changes in Inventory = 55,000 – 42,000 = 13,000
  • Cash inflow due to changes in Accounts Payables = 45,000 – 38,000 = 7,000
  • Total changes in Operating accounts = -16,000 + 13,000 + 7,000 = $4,000

Cash Flow From Operations Indirect Method = $170,000 + $0 + 14,500 + $4000 = $188,500

Cash flow from operating activities – Why it is important?


The cash flow from operating activities is always compared to the company’s net income. If the cash flow from operating activities is consistently higher than the net income, it can be safely assumed that company’s earnings are of high quality. It has been seen that analysts raise red flag when the cash flow from operating activities is lower than the net income. The question in this case is why the reported net income is not turning into cash for the company.

apple-cash-flow-from-operations-1

source: ycharts

The main reason why a company exists is to earn revenue and create shareholder revenue. This is the prime reason why the assessment whether the company has been able to generate cash by operating activities is an important component. As from above, we can see that Apple Incorporation in FY15 has generated $81,7 billion as cash from operating activities of which $53,394 billion has been generated as Net income.

Let us now have a look at another company’s cash flow from operations and see what it speaks about the company. This is the case of Box. The company for years didn’t generate accounting profit but investors kept putting money into the company on the backdrop of solid business proposition.

box-cash-flow-from-operations

source: ycharts

Our objective is to make you assess the importance of cash flows in the company and how it plays a critical component in the business world. Think of a pharma company which is doing strong R&D and there is a possibility of seeing a blockbuster patented drug being launched in few years’ time. During this period investors will be looking at the fact whether the company has enough cash to continue operations during this period.

Conclusion


As we have seen throughout the article we are able to see that cash flow from operations is a great indicator about the core operations of the company. It can help an investor gauge about the operations of the company and see whether the core operations are generating ample money in the business. If the company is not generating money from core operations, it will cease to exist in few years’ time.

Comments

  1. By Brandon HAWKINS on

    First of all I want to thank you for such a great article, you are doing a great job as always. I almost read all your blogs as specially the blogs related to finance, I do have a small question if you can tel me what is the importance of Free cash flow for business?

    Reply

    • By on

      thank you so much.As you must know Cash is the king, as blood is important to our body as so cash flow is also important for any kind of business, you also need cash flow to pay your debt commitments and run your day to day operations of the business. This excess cash is called as FCF i.e Free Cash Flow. You can learn about FCFF in detail here.

      Reply

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