Cash flow from Operations

What is Cash Flow from Operations (Operating Activities)?

Cash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year; Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.

‘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 is reflected in this part of the statement shows the changes made in cash, accounts receivables, inventory, depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, and accounts payable segment. Analysts community look into this section with hawkeye as it shows the viability of the business conducted by the company.

In the long run, if the company has to remain solvent at the net level’s cash flow from operations’ needs to remain net positive (or in other words, operations must generate positive cash inflows).

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Source: Cash flow from Operations (wallstreetmojo.com)

How to Prepare 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 were all to look into so that one can read the fine prints in this section.

The beginning point of this section is the net income figure, which is available from the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more of the company. If all of the company’s revenue was in the form of cash and there are no non-cash expenses, then this remains as the main figure. However, since, in reality, it is not true, hence the non-cash charges and credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more 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 statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more.

1^st month: There was no revenue in the first month and no such operating expenseSuch Operating ExpenseOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more; hence income statement will result in net income to be zero. In cash flow from the 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 activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more	$ -700.00

2^nd Month: During this month, the company was able to sell 10 product units priced at 80 dollars each. The delivery of the product was done on the 20^th of the month, and the buyer was provided an invoice worth 800 dollars due by the 10^th 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.

CFO 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 activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more	$                 –

Please note that the 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.

CFO activities (end of the second month)
Net Income	$        300.00
Increase in accounts receivables	$      -800.00
Increase in inventory	$      -200.00
Cash Provided (used) in operating activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more	$      -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, a 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. Hence the company at a cumulative level is standing negative on CFO.

3^rd 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 operating activities). Due to the purchase of the office equipment company also incurred non-cash depreciation charge of 20 dollars during the month.

CFO activities (for the third month)
Net Income	$                 –
Depreciation charge added back	$          20.00
Cash Provided (used) in operating activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more	$          20.00

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

CFO activities (end of a 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 activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more	$        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 show that Mr. X’s cash from operating activities is $120.

Calculating Cash Flow from Operations – Direct Method

Calculating Cash flow from Operations using direct method includes determining all types of cash transactions, including cash receiptsCash ReceiptsA cash receipt is a small document that works as evidence that the amount of cash received during a transaction involves transferring cash or cash equivalent. The original copy of this receipt is given to the customer, while the seller keeps the other copy for accounting purposes.read more, cash payments, cash expenses, cash interest, and taxes.

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

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

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

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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

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E) Cash Tax: Represents only taxes paid in cash

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Cash Flow from Operations Formula (Direct Method) = 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 Cash Flow from Operations using the Direct Method. 

The following additional information is available

• 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 formula =

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

Calculating Cash Flow from Operations using Indirect Method

Calculation of Cash flow from operations using the indirect method starts with the Net income and adjust it as per the changes in the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.

Steps to calculate cash flow from operations using the 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 the sale of land)

Step 3:

• Add: Non-cash charges to income (such as depreciation and goodwill amortizationGoodwill AmortizationGoodwill amortization refers to the process in which the cost of the goodwill of the company is expensed over a specific period of the time i.e., there is a reduction in the value of the goodwill of the company by the way of recording of the periodic amortization charge in the books of accounts.read more) 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 the 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 Formula (Indirect method) = 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 Cash Flow from Operations example we used for using the 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  Cash Flow from Operations using Indirect Method 

The following additional information is available

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

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 formula (Indirect Method) = $170,000 + $0 + 14,500 + $4000 = $188,500

Why is it important?

CFO is always compared to the company’s net income. If it is consistently higher than the net income, it can be safely assumed that the company’s quality of earnings is high. It has been seen that analysts raise a red flag when the CFO 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.

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 of 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 a solid business proposition.

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 that is doing strong R&D, and there is a possibility of seeing a blockbuster patented drug being launched in a 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 of 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 a few years’ time.

Cash flow from Operations Video

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