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What’s it: Cash flow from operating activities is the incoming and outgoing money related to daily operation. Its examples include sales revenue, production expenses, employee salaries, marketing expenses, and general and administrative expenses.
Operating activities vary between industries, depending on their core business. For manufacturers, the production and sale of goods are core activities. Meanwhile, for banks, lending and borrowing is their core business.
Knowing the core business is important for categorizing operating activities. Manufacturers earn money from selling goods. They can also earn interest income from the money they keep in the bank. However, because saving is not a core business, it is not the company’s main activity.
Under IFRS, interest income falls into operating or financing cash flows. Meanwhile, under US GAAP, it is an operating cash flow.
Difference between cash flows from operating activities, financing activities, and investing activities.
Companies can generate cash from a variety of different sources. We classify them into three categories. Apart from cash flows from operating activities, the other two are:
- Cash flows from investing activities relate to the acquisition or disposal of long-term assets.
- Cash flows from financing activities relate to injection or payment of capital.
Cash flows from operating activities appear at the top of the cash flow statement. This section shows you how much cash is going in and out of the company’s core business. It provides the best idea of how well the company’s business operations are making cash. Ideally, the company should book positive results from this activity.
Meanwhile, investment and financing activities are not directly related to the production of goods and services provision. They both tell you how the company grows in the long term and how they finance it. Both are important in maintaining a company’s long-term growth.
In the investment activity section, you will see how much the company’s capital expenditure is in a period. It usually covers a significant portion of this section.
Capital spending is important to determine the prospects for future business growth. By buying capital goods such as machinery and equipment, we expect the company to generate more income in the future. Companies may also build new facilities, which increase the company’s production capacity.
Acquisitions are also part of investing activities. It is a faster way to grow and strengthen the business position than internal growth.
Meanwhile, in the cash flow of financing activities, you will see how the company finances its long-term growth, including capital expenditures. Financing sources fall into two general categories: equity and debt. So, in this section, you will find several items such as issuing shares or bonds, paying off debt securities, paying dividends, and so on.
The choice of financing sources affects the company’s capital structure. Company leverage is high when relying too heavily on debt. That increases financial risk, limiting the company’s capacity to apply for new debt. Thus, they may have difficulty raising capital to finance investment.
Why is cash flow from operating activities important
First, investors evaluate cash flows from operating activities closely. It provides an idea of how successful the company is in making money from its primary activity.
This section indirectly reflects the competitive advantage and operational efficiency of the company. Take, for example, a manufacturing company. Under a cost leadership strategy, they excel when generating revenue by selling more products than competitors. At the same time, it operates at a low-cost structure. Its high revenues and low costs should be reflected in its operating cash flows if it does so successfully.
Furthermore, when adopting a differentiation strategy, the manufacturer charges a premium. Although the sales volume is not as significant as the cost leadership strategy, they can make a lot of money because they have a high-profit margin. Thus, the company’s operating cash flow should reflect this, as well.
Second, the company’s cash flow tells you how well the company is converting profits into cash. Manipulating operating cash flows is more complicated than a company’s net income. Net income calculation contains non-cash items such as depreciation or amortization.
Also, a company can manipulate net income by taking advantage of the flexibility in the accrual method. For example, when the growth in operating cash flow does not match revenue growth, it may adopt earnings management practices.
For this reason, to measure the quality of a company’s earnings, you can compare net cash flow from operating activities with net income. If high net income does not translate into high operating cash flow, it may adopt an aggressive revenue recognition policy.
The company should ideally have an operating cash flow that exceeds net income. The variability of operating cash flows and net income is an important determinant of the overall risk inherent in the company.
Third, positive cash flow from operating activities means the company has money left over for non-operating expenses. For example, they can use it to pay off debts, pay dividends, or finance future expansions.
Conversely, if cash flow is negative, the company must rely on other sources to finance some of its activities. That may be by issuing debt securities or shares. Or, the company sold some of its fixed assets. And if it lasts a long time, it indicates a severe problem with the company’s business.
Negative cash flows from operating activities.
Positive net operating cash flow is ideal. However, in some instances, negative cash flow is still tolerable.
An established company should have positive cash flow from operating activities instead of investing or financing activities. It shows they are successfully exploiting its core business. They can generate income by efficiently selling products. After paying all operational expenses, they still leave money for internal capital and pay off debts.
Conversely, startups, or growing companies, they have not made enough money from operating activities. As a result, operating cash flows are usually negative. They are developing and tend to book lower revenues than expenses.
New companies usually allocate large capital expenditures to support future growth. Therefore, they usually rely on financing to meet cash needs, either through shares or debt securities.
Once businesses have grown and reached a mature stage, they must generate positive cash flow from operating activities. It should be greater than routine capital expenditures (to compensate for depreciation and increase capacity). Thus, they have the remaining money to pay off debts and to pay dividends.
So, if it doesn’t work out, stakeholders see the company’s business as unhealthy. They have doubts about the sustainability of the company in the future.
Components of cash flow from operating activities
Cash flow describes the sources and uses of cash from the company’s regular activities. This includes the activities of production, distribution, product marketing, administration, and general maintenance.
You can break down the components from the income statement and working capital. In the income statement, you must exclude non-cash components such as depreciation and amortization. Cash inflows come from product sales. To generate these sales, the company spends a certain amount of cash, including to buy inventory, pay salaries, market products, manage administrative and general activities, and pay taxes.
Meanwhile, working capital is the difference between current assets and current liabilities. Its components consist of accounts such as trade receivables, inventories, and trade payables.
Following are examples of cash flow from operating activities:
- Selling products for cash
- Collecting accounts receivable
- Purchasing raw materials and other inputs from suppliers
- Paying salaries, remuneration of directors and employees, or long-term non-retirement employee benefits
- Paying for outbound and inbound logistics
- Paying for utilities, office rent, warehouse, or other equipment
- Paying for the services of external professionals or consultants such as advertising agencies and external auditors
- Paying taxes
Calculate cash flow from operating activities
Two methods for presenting a cash flow statement are:
- Direct method
- Indirect method
You can distinguish the two mainly in cash flow from operating activities. Under the direct method, the company breaks down all cash inflows and outflows. The accounts come from the income statement, current assets, and current liabilities.
Meanwhile, under the indirect method, the company starts with the income statement, namely net income. Then, it adjusts for non-cash components (such as depreciation and amortization) and changes in working capital.
Direct method
Under the direct method, companies present a breakdown of cash inflows and outflows during the accounting period. The cash outflow is deducted from the cash inflow to get the net operating cash flow. More or less, the general equation is as follows:
Net operating cash flow = Cash inflows – Cash outflows
Examples of direct methods for presenting statements of cash flows from operating activities using the direct method are as follows:
| Cash receipts from customers | 3,000 |
| Cash paid to suppliers | -900 |
| Cash paid to employees | -1,050 |
| Cash paid for other operating expenses | -200 |
| Interest is paid | -28 |
| Income tax paid | -350 |
| Net cash from operating activities | 472 |
Presenting items such as interest, dividends, and taxes on income is more flexible. For example, under IFRS, a company might classify interest and dividends as operating, investing, or financing cash flows as long as they are consistent from period to period.
Likewise, taxes are usually included in the category of operating activities. However, if companies can specifically identify with financing or investing activities, they can present it in another section.
More tricky is the main drawback of the direct method. You have to detail and classify cash payments and receipts. The process takes longer. Therefore, external users, such as analysts or investors, usually prefer indirect methods.
Indirect method
Under the indirect method, we calculate net operating cash by taking net income from the income statement. Since the income statement contains several non-cash items (such as depreciation and amortization), we need to add these components back. Another adjustment is for the impairment of assets and gains from the sale of non-current assets. The final stage is to add changes in working capital.
Formula for net cash from operating activities using the indirect method is as follows:
Net cash from operating activities = Net income + Adjustment components + Changes in working capital
Assume that the adjustment component consists only of depreciation and amortization. Examples of operating cash flows under the indirect method are as below:
| + Net income | 1,864 |
| + Depreciation & amortization | 1,206 |
| + Changes in working capital | 8.7 |
| Net cash from operating activities | 3,079 |
Let’s dig into a little more detail for working capital changes. We calculate working capital by subtracting current assets from current liabilities. It shows you the money the company needs to operate its day-to-day business.
Current assets comprise accounts such as inventories, accounts receivable, and accrued income. Meanwhile, current liabilities cover items such as trade payables, tax liabilities, and accrued expenses.
An increase in current assets reduces the company’s cash flow. Take, for example, accounts receivable. It occurs when the company has delivered goods but has not received cash payments. Thus, if it increases, the company collects less money from its customers, reducing cash inflows. Conversely, a decrease in accounts receivable indicates customers are paying earlier, which is positive for cash flow.
On the other hand, an increase in current liabilities increases operating cash flow. Let’s see what happens if the trade payable increases. Trade payable represents cash owed to suppliers. The company has received goods from suppliers but has not paid for them. If it increases, the company pays its suppliers longer, which is positive for cash flow. Conversely, if it decreases, the company pays its suppliers earlier, which is negative for cash flow.
Next, take a simple example of working capital calculation. Say, current assets and current liabilities consist only of trade receivables and trade payables, respectively. For example, in 2018, working capital decreased by around $100, from $500 to $400. It contributes negatively to cash flow from operating activities.
The company recorded an increase in cash owed by customers higher than the increase in trade payables. Trade receivable increased by $500 from $1,000 to $1,500, while trade payable increased by $400 from $1,500 to $1,900. Thus, on a net basis, the company’s cash flow decreases to $100.
| 2017 | 2018 | 2019 | |
| Trade receivable | 1,000 | 1,500 | 2,000 |
| Trade payable | 1,500 | 1,900 | 2,550 |
| Working capital | 500 | 400 | 550 |
| Changes in working capital | -100 | 150 |
