Cash Flow From Operating Activities (with Examples)

The first section of the cash flow statement, known as cash flow from operations or operating activities, provides a detailed account of the cash generated or used by a company’s core business activities. This section is critical because it focuses on the cash inflows and outflows related to the day-to-day operations of a business, excluding any cash flows associated with investing and financing activities. It serves as a key indicator of a company’s ability to generate sufficient cash to maintain its operational activities, pay expenses, and support growth. Moreover, analyzing cash flow from operations allows investors, creditors, and financial analysts to evaluate whether a company can meet its short-term obligations and sustain its business model over time.

Cash flow from operations can be calculated using two distinct methods: the direct method and the indirect method. Both methods are accepted under accounting standards and ultimately lead to the same final result, although they differ in their approach and presentation. The choice between the two methods depends on the company’s reporting practices and preferences, though the indirect method is more commonly used in practice.

The direct method of calculating cash flow from operations involves reporting actual cash receipts and cash payments directly. Under this approach, a company records cash received from customers and cash paid to suppliers, employees, and other operating expenses. It provides a clear and straightforward view of cash movements by focusing on the actual cash exchanged during the reporting period. For instance, cash inflows would include receipts from customers for sales, while cash outflows would include payments made to vendors, wages, and other operational costs. This method emphasizes the actual cash generated or used by a company’s business operations, offering a transparent and easy-to-understand representation of its operating performance. However, the direct method can be more time-consuming and complex because it requires gathering detailed information about cash transactions from all operating sources, which is why many companies opt for the indirect method instead.

On the other hand, the indirect method starts with net income from the income statement and adjusts it to account for non-cash items and changes in working capital to arrive at cash flow from operations. This method begins with the accrual-based net income figure and modifies it by adding back non-cash expenses like depreciation and amortization and subtracting non-cash income items. It also adjusts for changes in current assets and current liabilities. For example, an increase in accounts receivable reduces cash flow because it indicates that sales were recorded but cash has not yet been collected. Similarly, an increase in accounts payable would increase cash flow because the company has deferred cash payments to suppliers. The indirect method provides a reconciliation between accrual accounting and cash accounting by starting with net income and adjusting for the actual cash effects of operational activities.

Both the direct and indirect methods aim to provide the same final figure for cash flow from operations, but the way they present the information differs significantly. The direct method gives users a clear view of cash inflows and outflows associated with specific operational activities, making it easier to track cash transactions. However, the indirect method offers a more practical approach because it is easier to prepare using financial statements and accounting records. As a result, while the direct method provides more transparency regarding actual cash flows, the indirect method is more commonly used due to its simplicity and ease of application.

The cash flow from operations section is essential because it isolates the cash generated by the company’s primary business activities, providing valuable insights into operational performance and liquidity. This section excludes cash flows related to financing activities such as borrowing money or paying dividends and cash flows related to investing activities such as purchasing or selling long-term assets. By focusing solely on the cash generated or consumed by a company’s core operations, the cash flow from operations offers a way to assess whether a company can sustain its daily operations with its core business income.

For investors and analysts, cash flow from operations is a crucial metric because it offers a clearer view of a company’s financial health and ability to generate cash from its business model. While net income or earnings can provide insight into profitability, they are based on accrual accounting, which includes non-cash items and accounting adjustments that can distort the true cash position of a business. Cash flow from operations eliminates these distortions by focusing solely on actual cash transactions. This allows investors to determine if a company has sufficient liquidity to cover its expenses, invest in growth opportunities, repay debt, and return money to shareholders through dividends or share repurchases.

Likewise, creditors rely on cash flow from operations to assess whether a company can meet its financial obligations. A company with consistent and positive operating cash flows demonstrates a strong ability to generate cash from its regular business activities, reducing the risk of default on debt payments. This is particularly important for lenders who want assurance that the business will generate enough cash to cover interest payments and principal repayments.

The cash flow from operations section also provides insights into changes in working capital, which represents short-term assets and liabilities that impact a company’s cash position. Changes in accounts receivable, inventory, and accounts payable are key components of this analysis. For example, an increase in accounts receivable may indicate that a company’s sales are growing but that cash collection is lagging, potentially leading to cash flow challenges. Similarly, an increase in inventory could tie up cash that could have been used elsewhere, while an increase in accounts payable reflects delayed cash outflows, which could benefit short-term liquidity.

1) Direct Method Formula:
Cash Flows from Operating Activities = Cash receipts from customers - Cash paid to suppliers - Cash paid to employees - Other cash payments

Example:
Given the following information, calculate the cash flow from operations using direct method:
Net Sales $800,000
Credit Purchases $60,000
Opening Accounts Receivable $55,000
Closing Accounts Receivable $95,000
Opening Accounts Payable $85,000
Closing Accounts Payable $45,000
Opening Salaries Payable $150,000
Closing Salaries Payable $120,000
Salaries Expense $400,000
Beginning Interest Payable $25,000
Closing Interest Payable $30,000
Interest Expense $75,000

Solution:
Cash Receipts from Customers = Net Sales + Opening Accounts Receivable - Closing Accounts Receivable = 800,000 + 55,000 - 95,000 = $760,000
Cash paid to suppliers = Opening Accounts Payable + Credit Purchases - Closing Accounts Payable = 85,000 + 60,000 - 45,000 = $100,000
Cash paid to employees = Opening Salaries Payable - Closing Salaries Payable + Salaries Expense = 150,000 - 120,000 + 400,000 = $430,000
Other cash payments (Interest) = Beginning Interest Payable - Closing Interest Payable + Interest Expense = 25,000 - 30,000 + 75,000 = $70,000
Cash Flows from Operation = 760,000 - 100,000 - 430,000 - 70,000 = $160,000

2) Indirect Method Formula:
Cash Flows from Operating Activities = Net operating profit + Depreciation/Amortization + Loss on disposal of fixed asset - Profit on disposal of fixed asset + Increase in Current Liabilities - Decrease in Current Liabilities - Increase in Current Assets + Decrease in Current Assets

Example:
Given the following information, calculate the cash flow from operating activities using indirect method:
Net operating income $200,000
Depreciation expense $5,000
Loss on sale of motor vehicles $4,000
Increase in Prepaid Insurance $2,500
Decrease in Prepaid Rent $3,000
Decrease in Accounts Payable $8,000
Decrease in Accounts Receivable $5,000

Solution:
Cash Flows from Operating Activities
= Net operating income + Depreciation + Loss on sale of motor vehicles - Increase in Prepaid Insurance + Decrease in Prepaid Rent - Decrease in Accounts Payable + Decrease in Accounts Receivable
= 200,000 + 5,000 + 4,000 - 2,500 + 3,000 - 8,000 + 5,000
= $206,500