Cash Flow from Operating Activities (CFO) represents the amount of money a company generates from its fundamental business operations, such as manufacturing and selling goods or providing services. It is the first section in a company’s cash flow statement.
CFO excludes long-term expenditures like capital expenditures or investment earnings and expenses. Instead, it concentrates solely on the core business processes and is also referred to as Operating Cash Flow (OCF) or Net Cash from Operating Activities.
Key Takeaways
- Cash Flow from Operating Activities is an essential benchmark for assessing the financial success of a firm’s core business activities.
- CFO is the first section displayed on a cash flow statement, which also covers cash from investing and financing activities.
- Depicting cash flows from operating activities on a cash flow statement can be done in two ways: the indirect method and the direct method.
- The indirect method begins with net income from the income statement and then adjusts for non-cash items to derive a cash-basis figure.
- The direct method records all transactions in a period on a cash basis, reflecting real cash inflows and outflows on the cash flow statement.
The Importance of Understanding CFO
Cash flow is one of the most crucial components of business operations, representing the total amount of money moving in and out of a company. Its significance is multifaceted: it allows business owners to understand the sources and uses of money, helps maintain operational efficiency, and facilitates key financing decisions.
Details about a company’s cash flow are available in its cash flow statement, featured in quarterly and annual reports. Cash Flow from Operating Activities highlights the cash-generating capabilities of a company’s core activities and typically includes net income from the income statement, adjusted to change from an accrual accounting basis to a cash accounting basis.
Having liquidity allows a business to expand, launch new products, repurchase shares to demonstrate financial strength, pay out dividends to boost shareholder confidence, or reduce debt for interest savings. Investors look for companies with increasing cash flows from operations, as such companies often have the potential for higher share prices if cash flow is utilized effectively.
Positive and increasing CFO indicates that a company’s core business activities are fruitful, offering an additional measure of profitability apart from traditional indicators like net income or EBITDA.
The Structure of a Cash Flow Statement
A cash flow statement is one of the three major financial statements required in financial reporting, alongside the income statement and balance sheet. It is divided into three sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Together, these sections provide a comprehensive picture of a company’s cash sources, expenditures, and the net cash change during a specific accounting period.
Cash Flow from Investing Activities - This section details the cash used for purchasing fixed and long-term assets such as property, plant, and equipment (PPE) and proceeds from the sale of these assets.
Cash Flow from Financing Activities - This section outlines sources of a company’s funding, including proceeds from issuing stocks and bonds, dividend payments, and interest payments.
Investors scrutinize the CFO within the cash flow statement to understand where a company obtains its money from since operating activities represent core and recurring revenue sources, unlike investing or financing activities, which may not be regular.
Types of Cash Flow from Operating Activities
The CFO section can be presented via two methods:
Indirect Method
Under the indirect method, a company begins with net income on an accrual accounting basis and adjusts backward to ascertain a cash basis figure. Accrual accounting recognizes revenue when earned, not necessarily when received in cash.
Example: A customer buys a $500 widget on credit. Although the sale is made, the cash has not been received. The transaction is recognized in net income on the income statement but requires an adjustment from the cash basis. This would be shown on the cash flow statement as an “Increase in Accounts Receivable - $500.”
Direct Method
The direct method records all transactions on a cash basis and reflects actual cash inflows and outflows during the accounting period. Examples include:
- Salaries paid to employees
- Cash paid to vendors and suppliers
- Cash received from customers
- Interest income and dividends received
- Taxes and interest paid
Indirect Method vs. Direct Method
The indirect method is often preferred because it is simpler to prepare using information from the income statement and balance sheet. As most companies use the accrual accounting method, these other financial statements have figures consistent with it.
However, the Financial Accounting Standards Board (FASB) recommends the direct method, as it provides a transparent view of cash flows. Businesses using the direct method are also required by the FASB to prepare a reconciliation of net income to the cash flows from operating activities as if the indirect method had been used.
A reconciliation report, similar to the indirect method, begins by listing net income and adjusts for non-cash transactions and changes in balance sheet accounts, ensuring the accuracy of the operating cash flow. This additional task makes the direct method less popular among companies.
Indirect Method Formulas for Calculating CFO
The CFO value can be calculated by following different reporting standards, calculated using one of these formulas, which 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 Credit + Other Funds)
Cash Flow from Operating Activities = Net Income + Depreciation, Depletion, \& Amortization + Adjustments to Net Income + Changes in Accounts Receivables + Changes in Liabilities + Changes in Inventory + Changes in Other Operating Activities
Figures for all listed line items are available in companies’ standard cash flow statements. Net income comes from the income statement and needs adjusting for non-cash expenses such as depreciation and amortization and changes in balance sheet items.
From one reporting period to the next, any positive change in assets is subtracted from net income, while positive changes in liabilities are added. For example, an increase in accounts receivable indicates revenue recorded but not yet received in cash, while an increase in accounts payable reflects recorded expenses for which cash has not been paid.
Example of Cash Flow from Operating Activities
Consider Apple Inc.’s cash flow details for the fiscal year ending September 2018.
First Method Formula:
- Net Income: $59.53 billion
- Depreciation, Depletion, & Amortization: $10.9 billion
- Deferred Taxes & Investment Tax Credit: -$32.59 billion
- Other Funds: $4.9 billion
- Change in Working Capital: $34.69 billion
Summing these gives the Cash Flow from Operations as $77.43 billion.
Second Method Formula:
- Net Income: $59.531 billion
- Depreciation: $10.903 billion
- Adjustments to Net Income: -$27.694 billion
- Changes in Accounts Receivables: -$5.322 billion
- Changes in Liabilities: $9.131 billion
- Changes in Inventory: $0.828 billion
- Changes in Other Operating Activities: $30.057 billion
The net CFO value again comes to $77.434 billion.
Special Considerations
Working capital, an essential component of cash flow, can be manipulated by companies through various measures, affecting when they recognize or delay earnings and expenses. This can include delaying payments to suppliers, accelerating collections from customers, or deferring inventory purchases. Such capacity for manipulation means that CFO is more often used to compare one company’s performance over multiple periods, rather than comparing different companies.
It’s crucial for investors to be aware of these practices when comparing cash flow across companies, as it helps to account for variances that might arise from managerial discretion.
Related Terms: Cash Flow Statement, Operating Cash Flow (OCF), Capital Expenditures, Depreciation, EBITDA.
References
- U.S. Securities and Exchange Commission. “Beginners’ Guide to Financial Statement”.
- Internal Revenue Service. “Publication 538: Accounting Periods and Methods”, Page 10.
- Financial Accounting Standards Board. “Statement of Cash Flows (Topic 230) Classification of Certain Cash Receipts and Cash Payments”.
- U.S. Securities and Exchange Commission. “Apple Inc. Form 10-K”, Page 42.
- Yahoo Finance. “Apple Inc. (AAPL)”.
