What Does "Cash Flow from Operating Activities" Mean?
Cash flow from operating activities measures the cash-generating abilities of a company's core operations (rather than its ability to raise capital or buy assets).
Put another way, cash flow from operations is the amount of money a company brings in from their day-to-day business operations (e.g. selling goods, making products).
Cash flows from operations is the first section on a cash flow statement, which breaks down a company's cash inflow and outflow into three categories:
Cash flows from operations
Cash flows from investing activities, and
Cash flows from financing activities.
Cash flow from operating activities (CFO) may also be referred to as:
Operating cash flow (OCF)
Net cash provided from operating activities
How to Calculate Operating Cash Flow
There are two ways to calculate cash flow from operating activities on a cash flow statement:
The indirect method starts with the net income then works backward and applies adjustment for elements like depreciation and amortization (ie. non-cash items).
The direct method refers to a company’s income statement to track all cash-based transactions. It then uses cash-based transactions (cash inflow and outflow) to arrive at the CFO.
Indirect vs. Direct Cash Flow From Operating Activities
Below are the main differences between these two methods:
|Net income is converted for cash flow||Reconciliation is done to convert the cash flow|
|All factors are accounted for with adjustments including depreciation and amortization||Non-cash factors are ignored|
|Adjustments can yield a less accurate statement||No adjustments are needed, making this a more accurate calculation method|
The main difference between these two methods are the types of transactions used to generate the CFO. The indirect method converts income into cash flow and accounts for non-cash adjustments. Conversely, the direct method only takes cash transactions into account.
The Cash Flow Formula
The indirect method is by far the most common method for calculating cash flow from operations. Over 98% of public companies use the indirect method, as the direct method is often too complicated due to the requirement to classify potentially millions of transactions as either operating, investing, or financing which is incredibly costly and time consuming.
Why a Cash Flow Statement Is Important
Cash flow statements are essential for companies to analyze their ability to pay for goods, salaries, services, and debt. A company needs cash to survive and (hopefully) thrive.
For investors, cash flow statements provide key insights for smart investing decisions. Cash flow is a significant part in valuation models, and helps assess a company’s past and present business activities with a forecast for the future (for example discounted cash flow).
Cash flow measures are heavily influenced by a company’s cash from operations. In turn, this is heavily influenced by a company’s net income. This means that high revenue and low overhead are major drivers of cash flow from operating activities. Investors hunt for companies that have high (or improving) cash flow from operations but also have low share prices. The disparity often means that share prices will soon increase.
Tips for Examining the Cash Flow of Operating Activities
Investors should be aware that companies can influence cash flow from operating activities. This can happen by:
Lengthening the time they take to pay the bills (thus preserving their cash)
Shortening the time it takes to collect what’s owed to them (thus accelerating the receipt of cash), or
Delaying inventory purchases (again preserving cash).
Keep this in mind when comparing the cash flow of different companies. It’s important to review multiple financial statements to examine a company’s financial health.
Investors should also note that having negative cash flow for a period of time is not always a bad thing. For example, a company introducing a new product may experience a dip in cash flow. If the company's new product (categorized under operations) generates more cash in the future, this could pay off. If the company has a negative cash flow from operations because it made poor decisions, then the long-term benefit simply won’t materialize.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
Marketing jargon seems to permeate every aspect of our lives. In fact, getting pressured into buying seemingly valuable products you don't really need is a long-standing way of doing business in...Read More →
If you'd like us to answer one of your investing questions in our weekly Ask The Expert Q&A column, email us at...Read More →