Cash Flow From Operating Activities (CFO)

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What Is Cash Flow From Operating Activities (CFO)?

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.

Key Takeaways

  • Cash flow from operating activities is an important benchmark to determine the financial success of a company’s core business activities.
  • Cash flow from operating activities is the first section depicted on a cash flow statement, which also includes cash from investing and financing activities.
  • There are two methods for depicting cash from operating activities on a cash flow statement: the indirect method and the direct method.
  • The indirect method begins with net income from the income statement then adds back noncash items to arrive at a cash basis figure.
  • The direct method tracks all transactions in a period on a cash basis and uses actual cash inflows and outflows on the cash flow statement.

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Cash Flow From Operating Activities

Understanding Cash Flow From Operating Activities (CFO)

Cash flow forms one of the most important parts of business operations and accounts for the total amount of money being transferred into and out of a business. Since it affects the company’s liquidity, it has significance for multiple reasons. It allows business owners and operators check where the money is coming from and going to, it helps them take steps to generate and maintain sufficient cash necessary for operational efficiency and other necessary needs, and it helps in making key and efficient financing decisions.

The details about the cash flow of a company are available in its cash flow statement, which is part of a company’s quarterly and annual reports. The cash flow from operating activities depicts the cash-generating abilities of a company’s core business activities. It typically includes net income from the income statement and adjustments to modify net income from an accrual accounting basis to a cash accounting basis.

Cash availability allows a business the option to expand, build and launch new products, buy back shares to affirm their strong financial position, pay out dividends to reward and bolster shareholder confidence, or reduce debt to save on interest payments. Investors attempt to look for companies whose share prices are lower and cash flow from operations is showing an upward trend over recent quarters. The disparity indicates that the company has increasing levels of cash flow which, if better utilized, can lead to higher share prices in near future.

Positive (and increasing) cash flow from operating activities indicates that the core business activities of the company are thriving. It provides as additional measure/indicator of profitability potential of a company, in addition to the traditional ones like net income or EBITDA.

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.

Types of Cash Flow from Operating Activities

The cash flow from operating activities section can be displayed on the cash flow statement in one of two ways.

Indirect Method

The first option is the indirect method, where the company begins with net income on an accrual accounting basis and works backwards to achieve a cash basis figure for the period. Under the accrual method of accounting, revenue is recognized when earned, not necessarily when cash is received.

For example, if a customer buys a $500 widget on credit, the sale has been made but the cash has not yet been received. The revenue is still recognized by the company in the month of the sale, and it shows up in net income on its income statement.

Therefore, net income was overstated by this amount on a cash basis. The offset to the $500 of revenue would appear in the accounts receivable line item on the balance sheet. On the cash flow statement, there would need to be a reduction from net income in the amount of the $500 increase to accounts receivable due to this sale. It would be displayed on the cash flow statement as “Increase in Accounts Receivable -$500.”

Direct Method

The second option is the direct method, in which a company records all transactions on a cash basis and displays the information on the cash flow statement using actual cash inflows and outflows during the accounting period.

Examples of the direct method of cash flows from operating activities include:

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

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.

Indirect Method Formulas for Calculating Cash Flow from Operating Activities

Different reporting standards are followed by companies as well as the different reporting entities which may lead to different calculations under the indirect method. Depending upon the available figures, the CFO value can be calculated by one of the following formulas, as both yield the same result:

Cash Flow from Operating Activities = Funds from Operations + Changes in Working Capital

where, Funds from Operations = (Net Income + Depreciation, Depletion, & Amortization + Deferred Taxes & Investment Tax redit + Other Funds)

This format is used for reporting Cash Flow details by finance portals like MarketWatch.

Or

Cash Flow from Operating Activities = Net Income + Depreciation, Depletion, & Amortization + Adjustments To Net Income + Changes In Accounts Receivables + Changes In Liabilities + Changes In Inventories + Changes In Other Operating Activities

This format is used for reporting Cash Flow details by finance portals like Yahoo! Finance.

All the above mentioned figures included above are available as standard line items in the cash flow statements of various companies.

The net income figure comes from the income statement. Since it is prepared on an accrual basis, the noncash expenses recorded on the income statement, such as depreciation and amortization, are added back to the net income. In addition, any changes in balance sheet accounts are also added to or subtracted from the net income to account for the overall cash flow.

Inventories, tax assets, accounts receivable, and accrued revenue are common items of assets for which a change in value will be reflected in cash flow from operating activities. Accounts payable, tax liabilities, deferred revenue, and accrued expenses are common examples of liabilities for which a change in value is reflected in