Cash Flow from Operations (CFO) - Financial Edge (2024)

What is Cash Flow from Operations?

Cash Flow from Operations is used to calculate the amount of cash a company has generated from its operational activities during a specific period (e.g. annually). It is essentially the cash generated from the day-to-day core operations of the company. This is considered a good gauge of the company’s performance and liquidity as it focuses on the main product or services within a company.

Why is it Important?

This metric helps understand how much cash the day-to-day trading activities of the business generates. There’s less opportunity to manipulate the cash flow from operations compared to a company’s earnings.

Cash Flow from Operations vs Net Income

Cash Flow from Operating Activities (also known as Operating Cash Flow or OCF) is a process that converts Net Income (found on the Income Statement) to a “Cash Income” by adding back non-cash items and then taking the change in the balances of operating assets and liabilities. Net income is the profit determined for the period (based on the Revenues recorded), whereas Cash Flow from Operations monitors the movements of cash over the period. Both are key figures when analyzing a company.

How to Prepare Cash Flow from Operating Activities

There are two methods available for calculating operating cash flows: direct and indirect – both should yield the same result if calculated correctly!

Operating Cash Flow Formula (Indirect Method) with formula + example

Most businesses use the indirect method, which begins with Net Income and converts it to Operating cash flow (OCF) by making adjustments to items that do not affect cash when calculating net income.

The generic formula is:

Here is where you retrieve those figures:

• Use the Net Income figure from the Income Statement (from the end of the period)
• Non-cash items such as Depreciation and Amortization will be on the Income Statement (or in the Notes)
• Changes in Operating Working Capital are on the Balance Sheet (derived from changes in Accounts Receivable, Accounts Payable and Inventory from the previous year to the present).
• Note: it is important to be aware which movements on the Balance Sheet show a cash outflow and which are cash inflows.

Indirect Method Example

Company A compiled financial statements at year-end Year 1:

The Cash Flow from Operating activities is built as follows:

When creating a cash flow statement, it is important to calculate the changes in assets correctly. Inventory has increased over the period so there has been an outflow of cash. Payables (or money that is owed to the Company) have also increased so this is a cash inflow.

Points to Note

• Depreciation and amortization (D&A) are added back to Net Income as it was deducted in arriving at Net Income on the Income statement. It is not a cash expense; however, the purchase of a Non-Current Asset gives rise to a cash outflow and this would have been reflected elsewhere on the Cash Flow statement under Investing activities in the year of purchase
• The increase in Inventory is a deduction: if inventory rises on the balance sheet, it suggests that more inventory has been purchased so cash falls
• The increase in Accounts Receivable is a deduction: if receivables increase then part of the recorded sales are non-cash
• The increase in Payables is an addition: if payables increase then some costs were not made in cash

Operating Cash Flow Formula (Indirect Method) with formula + example

The direct method uses cash accounting to follow the cash movements over the specific period and is essentially subtracting the cash operating expenses from the cash sales generated by the core business.

The formula is:

Direct Method Example

Positive or Negative Operating Cash Flow?

A positive operating cash flow suggests that a company is operating well in its core business and generating cash. This cash can feed into discretionary free cash flow which is then used to meet other company’s needs such as shareholder return, financing arrangements or capex projects.

A negative OCF implies that the day-to-day running of the company’s core business is losing cash and requires additional cash (from other parts of the business or financing) to keep running. This may be due to a variety of reasons, some short-term (such as an inventory or one-off customer issue) or longer-term issues (falling sales, or deteriorating relationships with customers and suppliers).

OCF vs. FCF: What is the Difference?

Free cash flow is calculated by taking Operating Cash flow (i.e. the cash a company generates from its core operations) and also taking into account Capex spending over the period. Capital Expenditure (or Capex) is the cost of maintaining and improving the capital assets of the company, typically Property, Plant and Equipment. Whilst OCF only focuses on day-to-day operating activities, free cash flow takes this additional cost of running the company’s physical assets, such as the annual servicing of machinery in a factory.

Free cash flow can then be analyzed to determine how much cash a company has to do activities such as repaying debt, or returning cash to shareholders via dividends or buybacks.

Conclusion

Cash Flow from Operations is a valuable tool for assessing whether a company’s core business is generating (or losing) cash in its day-to-day activities. It also provides a metric to compare current performance against the company’s own historical performance. Analysts can gauge if the Cash Flow from Operations is improving and analyze what may be driving the change.

Efficient working capital management can be key to generating a consistent positive Cash Flow from Operations. It can be considered a better metric of a company’s health than Net Income as it is more difficult to manipulate. If a company is generating strong sales (and therefore profit), but unable to collect the cash from customers until a much later date, this will be evident in the Cash Flow from Operations.