Cash Flow from Operations

What is Cash Flow from Operations?

Cash flow from operations, also called operating cash flow, refers to the amount of cash garnered from a business’ core activities. This is typically calculated by taking a company’s net income, factoring in depreciation expenses, then adjusting for any gains or losses on sales and assets.

Cash flow from operating activities (CFO) indicates the amount of money a company brings in from its ongoing, regular business activities, such as manufacturing and selling goods or providing a service to customers. It is the first section depicted on a company’s cash flow statement.

Cash flow from operating activities does not include long-term capital expenditures or investment revenue and expense. CFO focuses only on the core business, and is also known as operating cash flow (OCF) or net cash from operating activities.

What Does Cash Flow From Operations Mean?

In laymen’s terms, cash flows from operations calculates how much money companies made from all the services and goods they sold or provided independent of their depreciation expense. This total is then adjusted to account for any changes in the value of the currency.

Companies tend to view operating cash flow as a more accurate metric for determining how well the business is really doing. A business could potentially have well over $100,000 in net income, yet have a cash flow that is substantially higher or lower than that amount. This is because after the net income is calculated, the depreciation expense is added to the net income total. This is done because net income is calculated to include accrued accounts and the cash flow metric looks at profits on a cash basis to see how much cash came in the door and how much went out during the year.

Thus, any paper expenses like depreciation and amortization must be added back in and any changes in asset and liability accounts must be adjusted for their effects on the cash balance of the company.

Cash Flow from Operations Formula

While the exact formula will be different for every company (depending on the items they have on their income statement and balance sheet), there is a generic cash flow from operations formula that can be used:

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

How to Analyze Operating Cash Flow

Operating cash flow is closely watched by analysts, since it can provide insights into the financial condition of a business. In particular, compare the amount of this cash flow to a company’s ongoing fixed asset purchasing requirements, to see if it is generating enough cash flow to fund its capital base. If not, it will either be necessary to obtain additional funding to maintain a sufficiently new set of fixed assets, or management can elect to replace assets at longer intervals, which can lead to higher repair costs and more production downtime.

Cash Flow Statement

The cash flow statement is one of the three main financial statements required in standard financial reporting – in addition to the income statement and balance sheet. The cash flow statement is divided into three sections—cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Collectively, all three sections provide a picture of where the company’s cash comes from, how it is spent, and the net change in cash resulting from the firm’s activities during a given accounting period.

The cash flow from investing section shows the cash used to purchase fixed and long-term assets, such as plant, property, and equipment (PPE), as well as any proceeds from the sale of these assets. The cash flow from financing section shows the source of a company’s financing and capital as well as its servicing and payments on the loans. For example, proceeds from the issuance of stocks and bonds, dividend payments, and interest payments will be included under financing activities.

Investors examine a company’s cash flow from operating activities, within the cash flow statement, to determine where a company is getting its money from. In contrast to investing and financing activities which may be one-time or sporadic revenue, the operating activities are core to the business and are recurring in nature.

How to Calculate Operating Cash Flow

There are two ways to calculate operating cash flow, which are the indirect and direct methods. The derivation of the two methods is noted below.

Indirect Method

To calculate operating cash flow under the indirect method, subtract all depreciation, amortization, income taxes, and finance-related income and expenses from the reported net income of a business. Conversely, it can also be calculated by subtracting all operating expenses (less depreciation and amortization) from revenues. Depreciation and amortization are subtracted because they are non-cash expenses. The method chosen depends on which information is more readily available.

In addition, the effects of changes in the various working capital line items on the balance sheet must also be taken into account. For example, an increase in accounts receivable represents a cash outflow, while a decrease in accounts receivable represents a cash inflow. Or, to use a liability as an example, an increase in accounts payable is a cash inflow, while a decrease in accounts payable is a cash outflow. This analysis is also conducted for inventory, prepaid expenses, accrued expenses, and accrued revenue.

Direct Method

To calculate operating cash flow under the direct method, a business uses cash-basis accounting to directly track the cash impact of all business transactions. This results in a statement of the cash inflows and outflows associated with a variety of line items, such as the following:

+ Cash collected from customers
+ Interest income and dividends received
– Compensation paid to employees
– Cash paid to suppliers
– Interest paid to lenders
– Income taxes paid
= Operating cash flow

Indirect Method vs. Direct Method

Many accountants prefer the indirect method because it is simple to prepare the cash flow statement using information from the income statement and balance sheet. Most companies use the accrual method of accounting, so the income statement and balance sheet will have figures consistent with this method.

The Financial Accounting Standards Board (FASB) recommends that companies use the direct method as it offers a clearer picture of cash flows in and out of a business. However, as an added complexity of the direct method, the FASB also requires a business using the direct method to disclose the reconciliation of net income to the cash flow from operating activities that would have been reported if the indirect method had been used to prepare the statement.

The reconciliation report is used to check the accuracy of the cash from operating activities, and it is similar to the indirect method. The reconciliation report begins by listing the net income and adjusting it for noncash transactions and changes in the balance sheet accounts. This added task makes the direct method unpopular among companies.

Example of Operating Cash Flow

A business reports its operating cash flow using the indirect method. It reports net income of $100,000, depreciation of $8,000, and income taxes of $30,000. Its accounts receivable increased by $20,000, while its accounts payable increased by $12,000. Its operating cash flow is:

$100,000 Net income + $8,000 Depreciation + $30,000 Income taxes - $20,000 Receivables + $12,000 Payables = $130,000 Operating cash flow

Operating Cash Flow vs. Net Income

There are significant differences between operating cash flow and net income. While operating cash flow is essentially the cash spun off from operating activities, net income is revenue minus expenses. The net income figure reported by a business can differ substantially from its operating cash flows, because net income includes non-cash revenues and non-cash expenses. For example, revenue might be recorded for which a billing has been issued to the customer, but for which no cash payment has yet been received. Or, a business records depreciation expense or accrues an expense, for which there are no associated cash outflows. These differences can result in operating cash flow being substantially higher or lower than net income. Neither value is more correct than the other; however, when net income persistently exceeds operating cash flows for an extended period of time, this is a possible indicator of financial statement reporting fraud, where the statements are being adjusted to report more income than is really the case.

Why Is OCF Important?

At its core, operating cash flow reveals the short-term financial health of a company. Investors and pending business partners seek out OCF on financial statements to see whether a company generates enough money to continue its day-to-day business.

If a company has a negative operating cash flow, it means its current cash inflow cannot cover its current cash outflow. A business with a negative OCF must rely on other financing activities—such as borrowing against the value of its current assets—to finance its capital expenditures. Some investors may accept or expect a negative operating cash flow for a startup company, but established companies operating with a negative OFC ratio may be less likely to attract investors.

How Does OCF Differ From Other Types of Cash Flow?

Under most business accounting standards, companies measure cash flow in one of three ways: operating cash flow, free cash flow, and cash flow forecast.

  • Operating cash flow: Operating cash flow, or OCF, helps measure a company’s financial health by factoring in its operating income (also known as earnings before interest and taxes, or EBIT) alongside its operating expenses. A positive OCF indicates the company can pay its bills using only its operating revenue. A negative OCF indicates the company must find other sources of money—typically via loans, taking on investors, or liquidating assets—to cover its operating expenses.
  • Free cash flow: Free cash flow, or FCF, represents the cash flows a company receives after capital expenditures (such as the purchase of long-term assets) have been deducted and before interest payments have been accounted for. Free cash flow appears on financial statements to show not only a company’s incoming cash flow but also how it manages capital expenditures (sometimes called CAPEX).
  • Cash flow forecast: A cash flow forecast, or CFF, can be calculated with the formula: Ending Cash = (Beginning Cash + Projected Cash Inflows) – Projected Cash Outflows. It partially overlaps with the indirect method for OCF because it anticipates future monies flowing through the accounts payable and accounts receivable departments.