What is Cash Flow from Operating Activities (CFO)?

Cash flow is the liquid assets a business receives from its core operations. Companies use cash flow from operating activities as a reporting metric for success. Organizations employ different methods to report their cash flow depending on reporting requirements and accountant preferences and can make adjustments to the business as necessary.

Companies use several metrics to determine success, including cash flow. A cash flow report is one of several documents a company typically files with investors and regulators. Part of the cash flow report, the cash flow from operating activities, helps uncover if a company’s core operations are paying off.

What Does Cash Flow Mean?

Cash flow refers to the movement of cash and cash equivalents that move in and out of a business during a particular accounting period. Companies determine their net cash flow with the following equation:

Net cash flow = total cash inflow – total cash outflow

The net cash flow appears on a cash flow statement that summarizes all transactions during this period. It includes both the activities that generate cash and those that require expenditure.

Companies release cash flow statements as part of their quarterly and annual reports. CFO describes the cash-generating abilities of that organization’s core business activities.

Is It the Same as Net Income?

Net income and cash flow are similar, but they include different values. A business’s net income represents its profits, whereas cash flow represents the cash available to spend on growth or distribution. Net income describes a company’s net revenue after subtracting expenses for that period.

Businesses report cash flow and net income on separate statements. The differences down as follows:

Cash Flow

• Describes the net amount of cash a company generates for a specific period
• Calculated by subtracting a company’s total cash outflow from the inflow
• Allows investors to estimate future cash flow based on historical information

Net Income

• Describes earnings after accounting for all expenses over a specific period
• Calculated by subtracting a company’s total expenses from total revenue
• Helps investors identify company profits after paying expenses

What Does Cash Flow from Operations Include?

The cash flow from operations typically includes the following items :

• Cash received from customers
• Cash paid to suppliers
• Cash paid to employees
• Cash-paid operating expenses
• Cash paid for income taxes

Calculating Cash Flow From Operating Activities

Companies can use two methods for displaying their cash flow from operating activities: indirect and direct .

Indirect

The indirect method is a simple way to generate a cash flow statement. Which is why most small- to medium-sized businesses favor it. An organization starts with the net income for a given period and then makes changes to determine the amount of cash available on hand.

Direct

Larger businesses and corporations typically use the direct method. A company that favors direct methods of generating cash flow statements records all cash transactions and displays that information using actual cash inflows and outflows for a given accounting period.

Some of the listed information on this type of statement can include:

• Employee salaries.
• Vendor and supplier payments.
• Customer payments.
• Interest income and dividends received.
• Income tax and interest paid.

Examples of Direct and Indirect CFO

Many accountants prefer the indirect method because of its simplicity. Because most companies use the accrual method of accounting, income statements and balance sheets will share consistent figures. However, the Financial Accounting Standards Board (FASB) recommends the direct approach due to the more precise picture of cash flow it often provides.?

Direct Example

This example provides a financial statement user with a detailed view of where the cash came from and what the company used it for.

Indirect Example

The indirect cash flow method may lead to different calculations depending on available figures. For example, an accountant or bookkeeper may use the following formula:

Cash Flow from Operating Activities (CFO) = Funds from Operations + Changes in Working Capital.

In the above formula, Funds from Operations = (Net Income + Depreciation, Depletion and Amortization + Deferred Taxes and Investment Tax Credits + Other Funds)

Another formula companies can use is:

CFO = Net Income + Depreciation, Depletion and Amortization + Adjustments to Net Income + Changes in Accounts Receivable + Change in Liabilities + Change in Inventories + Changes in Other Operating Activities

Why is Cash Flow from Operating Activities Important?

Knowing cash flow from operating activities is critical for companies . It gives a sense of a company’s business performance and the liquid assets on hand for expansion. Profitable companies that cannot pay their bills often fail to understand how managing their cash flow impacts operating expenses.

Cash flow from operating activities, combined with cash flow from investments and financing, allows businesses to perform a cash flow analysis. But cash flow from operating activities is often the most critical piece of the puzzle. It measures how much cash an organization produces through its primary operations — not its fundraising or the sale of its assets.

Understanding cash flow from operating activities becomes vital as companies continue to grow. Companies cannot expand without on-hand cash to purchase inventory or hire staff. Increasing costs and extended billing cycles can also impact cash flow. Being able to weather those challenges mitigates risk down the road.

Companies must also report operating cash flow as part of quarterly and annual reports with the Securities and Exchange Commission (SEC) .

Interpreting Cash Flow from Operations

While it is not the only portion of the cash flow equation, cash flow from operations does provide insights into what a business can do better. Companies that want to improve their cash flow can take steps to reduce the cost of goods and services to help grow the bottom line. Reducing overhead through partnerships with less expensive vendors and cutting inventory can also help.

Final Thoughts

Cash flow reports are one of the primary financial statements a business must file. A key component of operating a business is accurately reviewing and reflecting on what they are telling a business owner or investor. Companies must understand how negative cash flow impacts a business’s capacity for growth and how to use that information to adjust operating expenses when necessary.?

Top Takeaways

• Cash flow from operating activities describes the liquid assets a business receives from its core operations.
• Cash flow differs from net income in that cash flow does not account for activities such as capital investment.
• Companies can use indirect and direct methods to report their cash flow.
• Cash flow can help determine whether a company can purchase equipment or hire new employees.

(Reporting by NPD)