Cash Flow Statement – Cash Flows from Operating Activities

The cash flows from operating activities (CFO) section comes first and tells you how much cash the company has generated from its core business, as opposed to all transactions that are not investing or financial in nature. This is the area you should pay the most attention to because it provides the best picture of how well a company’s operations are generating cash that ultimately benefits shareholders.

In short, the CFO section includes transactions related to providing goods and services to customers and the payment of expenses related to the generation of revenue (i.e. “income statement” activities) and excludes non-cash expenses and non-operating gains/losses.

If amount of CFO is negative, the company is spending more cash than it is generating in producing and selling its goods and services; if amount of CFO is positive, the company is generating more cash than it is spending on its day-to-day operations.

Needless to say, cash flow from operations is vital. Negative cash flow from operating activities will eventually lead companies to seek funding from outside sources, either through increased debt load—which increases interest payments, hinders growth and makes the company more vulnerable to business downturns—or by issuing stock, which dilutes ownership. Although a rapidly growing company may have negative operating cash flows as it expands its inventory and pays its increasing bills, the cash flow from operating activities must eventually turn positive for the company to survive. Conversely, a contracting company may exhibit positive cash flows for a period of time, as spending falls at a faster rate than sales and earnings. If the sales and profi ts fall far enough, however, the company will have to liquidate portions of its business or declare bankruptcy.

IFRS does not mandate where cash flows relating to the servicing of finance and investment income should be presented, these could be in operating, investing or financing activities. IFRS permits two presentations of operating cash flow: the direct and indirect methods.


Indirect Method

In indirect method, the net income figure from the income statement is used and then adjust for non-cash expenditures to calculate the amount of net cash flows from operating activities. Since the income statement is prepared on accrual basis in which revenue is recognized when earned and not when received, therefore net income does not represent the net cash flows from operating activities. It is necessary to adjust earnings before interest and tax (EBIT) for those items which effect net income although no actual cash is paid or received against them.

Non-Cash Expenses

Non-cash expenses are non-operating expenses: no real cash payment and receipt. So, these expenses added back to net income (removed from operating profit). Typically, depreciation and amortization are the first or second line item that is reconciled. Both are a noncash expense, meaning that both do not require the expenditure of cash. Rather, both are used to reduce the value of an asset throughout its useful life in an effort to properly match revenues with expenses. Both these figures lower net income and shareholder’s equity, but since they do not affect a company’s cash balance, they are added back to net income. Examples:

Non-Operating Gains / Losses

Non-operating gains / losses involves cash payment and receipt, but these transactions are not part of business day-to-day operations. So, these transactions added back to net income (removed from operating profit). Example:

Changes in Working Capital

Working capital is calculated as current assets minus current liabilities on the balance sheet. Just as the name suggests, working capital is the money that the business needs to “work.” Therefore, any cash used in or provided by working capital is included in the “cash flows from operating activities” section.

The official definition of Working Capital is: Working Capital = Current Assets – Current Liabilities

Changes in Working Capital vs Working Capital
Changes in Working Capital vs Working Capital

Refer to the figure (Changes in Working Capital vs Working Capital), if we use the official definition of calculating working capital, the formula will not affect a company’s Cash Flow from Operations in a way that is consistent with the Changes in Working Capital in the Cash Flows from Operating Activities.

Cash Flow from Operations care about the changes in operational items on the Balance Sheet. It excludes the following balance sheet items:

  1. Cash balance – the Net Change in Cash appears (at the bottom of the Cash Flow Statement) impact this item.
  2. Investments – they are part of the company’s Investing Activities.
  3. Debt-related – they are part of a company’s Financing Activities.

Therefore, formula of working capital can be refined as:

Working Capital = Current Assets (Excluding Cash and Investments) – Current Liabilities (Excluding Debt)

We define the Change in Working Capital as: Change in Working Capital = Old Working Capital – New Working Capital

Normally, when we calculate a “Change,” we take the new number and subtract the old number. So why is it different here? To answer this question, let say a company’s Working Capital consists of only Inventory.

In Year 2, the company has $500 in Inventory, and in Year 1, it had $300 in Inventory. Its Working Capital was $300 in Year 1 and $200 in Year 2. Since the company’s Working Capital increased and Working Capital consists of only Inventory, its Inventory must have increased. And if Inventory increased, the company must have spent cash to do that.

If you calculated Working Capital this way: New Working Capital – Old Working Capital, it would show up as a positive $200 on the Cash Flow Statement, which is wrong. Therefore, to calculate the Change in Working Capital on the Cash Flow Statement, we must use Old Working Capital – New Working Capital.

When a company’s working capital increases, the company uses cash to do that. When working capital decreases, it frees up cash.

For example:

  • An increase in accounts receivable increases net income and shareholder’s equity since a sale has been made and the company can reasonably expect payment in the future. However, cash has yet to be received for accounts receivable. In order to adjust net income to cash flow, the increase in accounts receivable for the period must be subtracted from net income.
  • Prepaid expenses are assets on the balance sheet that do not reduce net income or shareholder’s equity. However, prepaid expenses do reduce cash. Adjusting for an increase in prepaid expense is similar to adjusting for an increase in accounts receivable: they both decrease cash flow.
  • Conversely, accounts payable measures payment owed to suppliers. An increase in accounts payable decreases net income, but increases the cash balance when adjusting net income in the cash flow statement. An easy way to see this increase is to recognize that a company taking longer to pay its bills will see a rise in its cash balance as well as its accounts payable.
  • Unearned revenues is a liability, so it works in the same way as accounts payable. An increase in unearned revenues does not affect net income or shareholder’s equity, but it does increase cash since payment has been received for future delivery of products or services.

Note: not all receivable and payables relate to operating cash flows; for example the company may owe money to vendors of property and equipment purchased or be owed for a disposal.

Here’s a little secret that’s all you really need to remember regarding changes in working capital:

  • If balance of an asset increases, cash flow from operations will decrease.
  • If balance of an asset decreases, cash flow from operations will increase.
  • If balance of a liability increases, cash flow from operations will increase.
  • If balance of a liability decreases, cash flow from operations will decrease.

Adjustment for taxes

Companies often maintain two sets of accounting books — one for reporting to tax authorities and one for reporting to shareholders. It may be advantageous for a company to pay a large tax bill up front and slowly deduct the expense from earnings over the next several years. As the tax expense is realized in subsequent periods, earnings and shareholder’s equity will decrease, but cash is not expended. A deferred tax expense on the cash flow statement is used to adjust net income to the cash balance.

Direct Method

CFO Direct method calculates cash flows from operating activities by involving various types of cash receipts and payments. The direct method of cash flow statement reconciliation reports major sources of cash receipts and payments, starting with cash receipts from customers. Cash payments for inventory purchases and operating expenses are deducted from this initial balance to arrive at cash flow from operating activities.

Here is an example of CFO Direct used by EMC Corp.

Net Operating Cash Flow

Net operating cash flow is the sum of the previous line items. Expanding companies may have negative operating cash flows as they build up inventory and provide more credit to customers, but eventually this figure needs to turn positive. For most companies, positive operating cash flow is crucial.

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