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A company must produce three important financial statements: income statement, balance sheet and a cash flow statement.

Traditionally a company produced just a balance sheet and income statement. Cash flow statements were introduced to help investors understand where companies were spending cash and generating cash. The cash flow statement also helps investors understand the link between earnings and cash flow.

A cash flow statement consists of three important categories: operating, investing and financing activities. We will focus on the operating activities of a cash flow statement.

What Is Cash Flow from Operations?

It’s a category in a cash flow statement that reports the amount of cash a company has generated from operational activities during a specific period. Those activities are related to providing a product or a service.

Otherwise known as the cash flow from operations (CFO), operating cash flow converts net income to cash income by adding back non-cash items and then taking the change in the balances of operating assets and liabilities.

The Formula

Two methods are available for calculating operating cash flows: direct and indirect – both yield the same result.

Most businesses use the indirect method, which begins with net income and converts it to OCF by making adjustments to items that do not affect cash when calculating net income.

The generic formula is:

Cash Flow from Operations = Net Income + Non-Cash Items + Changes in Operating Working Capital +/- Changes in Other Long Term Operating Assets and Operating Liabilities

 Here’s where you retrieve those figures:

Example

Company ABC compiled financial statements at year-end 2016:

2016 2015
Net Income 10.0 MM 9.0 MM
Depreciation & Amortization 1.5 MM 1.5 MM
Inventory 10.9 MM 6.0 MM
Accounts Receivable 7.4 MM 4.0 MM
Accounts Payable 7.3 MM 3.0 MM

 

Changes in Operating Working Capital = (Inventory) + (Accounts Receivable) + Accounts Payable
= (4.9 MM) + (3.4 MM) + 4.3 MM
= (4.0 MM)

 

Cash Flow from Operations $
Net Income 10.0 MM
+ Depreciation and Amortization 1.5 MM
+ Changes in Operating Working Capital (4.0 MM)
= 7.5 MM

Points to Note

  • Depreciation and amortization is added back to net income as it was deducted in arriving at that figure. It is not a cash expense, however, the purchase of a non-current asset gives rise to a cash outflow and this would have been reflected under investing activities in the year of purchase.
  •  The increase in inventory is a deduction: if inventory rises, more inventory is purchased so cash falls.
  • The increase in accounts receivable is a deduction: if receivables increase then part of the recorded sales are non-cash.
  • The increase in payables is an addition: if payables increase then some costs were not made in cash.

Why Is Cash Flow From Operations Important?

The cash flow from operation helps understand how much cash the day to day trading activities of the business generates. There’s less opportunity to manipulate the cash flow from operations compared to a company’s earnings.

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