Operating activities refer to the main business activities directly related to the supply of goods or services. Examples are manufacturing, distribution, marketing, and selling activities for products or services.
Why is cash flow from operating activities important?
The main business activity categories can vary between businesses. For manufacturers, the production of goods is an operational activity. From manufacturing, they get money. Likewise, lending money is the main activity of banks. Interest income represents bank revenues.
Manufacturers may also earn interest income from the cash they save. But, saving is not its operating activities, so do with interest income.
Thus, operating activities will generally provide the majority of the company’s cash flow. Examining operating profit components will help you assess how profitable the company is in running the business. Furthermore, you can also check which segment the company’s profitability is coming from.
Also, investment in working capital falls under the category of operating activities. Working capital is the current assets minus current liabilities. It consists of items such as accounts receivable, inventories, trade payables, and they are related to daily operations.
The difference between operating activities, financing activities and investment activities
Investment and financing activities are not directly related to the supply of goods and services. Both of them tell you how companies grow and how they finance business activities. Both are vital in sustaining the company’s long-term growth.
Investment activities, for example, buying capital goods, allow companies to produce more in the future. Likewise, with the establishment of a new factory, it makes the company’s production capacity increase. Acquisitions are also investments in growing and strengthening business positions.
Growth requires optimal financing and capital structure. When the company’s leverage is high, they may miss out on opportunities to grow. Their capacity to increase debt is limited. Thus, they have difficulty in raising capital to finance investment.
In the financial report
You can find operating activity accounts on the cash flow statement and income statement. Many companies present operating profit in their income statements. Also, the cash flow statement divides its components into three groups. They are cash flow from operating activities, investment activities, and financing activities.
Some companies present operating profit. Still, indeed, not all companies do it. To calculate it you can deduct revenue with summed items of:
- Cost of goods sold
- Selling expenses
- General and administrative expenses
- Research and development expenses
- Depreciation and amortization expenses
For some companies, interest and dividend income are excluded because they are not part of the company’s core business activities.
Conversely, banks and similar businesses include interest income as operating income. That’s because their main activity is lending and borrowing money. Banks earn revenue from the difference between lending rates with deposit rates.
Cash flow statement
The cash flow statement classifies the items into three subsections, namely:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Cash flow from operating activities is an essential part. Many users focus on this section. They want to see how much companies can make money (cash) from their business activities. Positive cash flow is preferable.
Conversely, negative cash flow is a warning. When it’s negative, the company spends money to finance business activities. The money they spend is higher than what goes in. In such situations, the company must borrow from creditors or sell its fixed assets. Of course, that is an unfavorable condition.