Cash from operating activities is the pulse check of a company’s core activities, a direct measure of its ability to turn sales into actual, usable money. It tells the unvarnished truth about whether a company can pay its bills, invest in growth and stay afloat.
While profits can be manipulated through clever (yet legal) accounting practices, cash doesn’t lie. As the saying goes,
“Revenue is vanity, profit is sanity, but cash is king.”
So, what is cash from operating activities, why is it important, what are its main components, and how is it calculated?
Be sure to reinforce your learning with our free quiz at the end!
What is Cash From Operating Activities?
Cash from operating activities, or cash from operations (CFO), represents the net cash generated by a company’s core operations. It reflects the cash inflows and outflows from a company’s primary operations, like selling goods and services and managing day-to-day expenses.
It is the first of three sections on a statement of cash flows (cash flow statement), presented before cash from investing activities and cash from financing activities.
By focusing on how and how much profit is converted to cash, cash from operating activities is a critical indicator of a company’s ability to sustain itself.
Why Is It Important?
Because cash from operating activities isn’t easily manipulated, it offers a more reliable view of a company’s financial performance and overall health. (It’s more difficult to manipulate because it tracks a company’s physical cash movements). On the other hand, net profit can be impacted by non-cash items and accounting practices, possibly skewing the reality of a company’s financial performance.
Other reasons of importance can be summarised in the following points.
Reflects Operational Health
Cash from operating activities suggests whether a company’s core operations are self-sustaining.
A positive and growing cash from operating activities indicates that a company generates sufficient funds to cover its operating expenses and other financial obligations. A negative CFO means a company would rely on external financing (like debt) or asset sales to cover these obligations.
Evaluates Profit Quality
Cash from operating activities helps assess a company’s annual profits and how effectively it converts profit to cash.
A company can report high annual profits, but if cash from operations is low, it isn’t converting much profit to cash. This could indicate excessive sales on credit, poor receivable collection practices (collecting money from customers who bought goods/services on credit) and other operational inefficiencies.
Highlights Financial Red Flags
Trends in cash from operating activities can provide early warning signs of financial trouble. Companies can (legally) manipulate profit to mask potential issues but not cash.
Negative cash from operations over extended periods can signal issues, including poor working capital management. When a company mismanages its working capital (current assets minus current liabilities), it may have to rely on debt to pay suppliers and employees and cover other core activities.
If the company cannot access external funding and continues to generate negative cash from operating activities, it may file for bankruptcy.
Cash From Operating Activities Components & Impacts
Cash from operations is derived from summing the cash inflows and outflows directly related to a company’s core business activities and can be calculated using the direct or indirect method.
The direct method lists and totals all the cash inflows and outflows related to a company’s operating activities. The indirect method starts with a company’s net profit and adjusts for non-cash items and changes in working capital.
Most, if not all, companies use the indirect method, so we’ll explain the components from the indirect method perspective.
1) Net Profit
Net profit, or profit after tax, is a company’s remaining revenue after accounting for all business expenses. It serves as the baseline for calculating cash from operating activities but needs adjusting as it includes some non-cash items.
2) Non-Cash Items
Non-cash items represent income (gains) and expenses (losses) included in net profit that do not affect a company’s cash position – no cash is received or paid as part of these transactions.
Since non-cash gains increase net profit, they are deducted when calculating cash from operating activities. Similarly, non-cash expenses decrease profit and are therefore added back in. These adjustments must be made because cash from operating activities only deals with cash inflows and outflows.
Some non-cash adjustments and their impacts on cash from operations are as follows.
Depreciation and Amortisation
- Explanation: These reduce the value of assets over time but do not affect cash. They are recognised as operating expenses and are therefore required to calculate profit.
- Impact on CFO: Added back to net profit (increases CFO) because they are non-cash expenses.
Stock-Based Compensation
- Explanation: Sometimes, companies pay employees with stock instead of cash. These stock payments are recognised as expenses (employee wages) and reduce profit.
- Impact on CFO: Added back to net profit (increases CFO) because they are non-cash expenses.
3) Changes in Non-Cash Working Capital
Changes in non-cash working capital show how cash is affected by changes in current assets and liabilities. The impacts of these changes are as follows.
Increase in Non-Cash Current Assets
- Explanation: An increase in current assets represents a cash outflow. To increase inventory, a company must spend cash. Similarly, when accounts receivable (the amount customers owe for buying goods on credit) increase, a company waits longer to receive that cash.
- Impact on CFO: Decreases cash from operating activities because it represents a cash outflow.
Decrease in Non-Cash Current Assets
- Explanation: A decrease in current assets represents a cash inflow. When inventory is sold (decreases), a company receives cash. Similarly, when accounts receivable decrease, a company collects the money it was previously waiting on.
- Impact on CFO: Increases cash from operating activities because it represents a cash inflow. It reflects the conversion of non-cash current assets into cash.
Increase in Non-Cash Current Liabilities
- Explanation: An increase in current liabilities represents a cash inflow. When accounts payable increase, a company has delayed payments to its suppliers (within the terms agreed). Since cash wasn’t paid when it was supposed to, it is seen as an inflow.
- Impact on CFO: Increases cash from operating activities because it’s a cash inflow – the company is holding on to money longer.
Decrease in Non-Cash Current Liabilities
- Explanation: A decrease in current liabilities represents a cash outflow. Cash is used to pay suppliers (accounts payable).
- Impact on CFO: Decreases cash from operating activities because it’s a cash outflow. It indicates the payments of short-term obligations.
4) Net Cash From Operating Activities
This represents the total cash flows from a company’s operating activities.
Positive Net Cash From Operations
- Explanation: Cash inflows exceed cash outflows – a company generates more cash from its core operations than it spends on it.
Negative Net Cash From Operations
- Explanation: A company spends more on its core operations than it generates from it.
Calculating Cash From Operations
Using the following information for Example Industries, here’s an example of calculating a company’s cash from operations using the indirect method.
Table 1: Example Industries’ Financial Information
| Operating Activity | Transaction Amount |
| Net Profit | 75,000 |
| Depreciation and Amortisation | 15,000 |
| Stock-Based Compensation | 7,000 |
| Increase in Accounts Receivable | 10,000 |
| Increase in Inventory | 5,000 |
| Increase in Accounts Payable | 10,000 |
Table 2: Calculating Example Industries’ Cash From Operating Activities
| Operating Activity | Inflows/(Outflows) in £m |
| Net Profit | 75,000 |
| Add: Depreciation and Amortisation | 15,000 |
| Add: Stock-Based Compensation | 7,000 |
| Subtract: Increase in Accounts Receivable | (10,000) |
| Subtract: Increase in Inventory | (5,000) |
| Add: Increase in Accounts Payable | 10,000 |
| Net Cash From Operating Activities | 92,000 |
Key Takeaways
- Net profit is often used as the baseline to calculate cash from operating activities, though companies may choose other starting points.
- Non-cash expenses, like depreciation and amortisation, are added back.
- Changes in non-cash current assets and liabilities are adjusted based on their impacts on cash.
- The result is a reconciliation of net profit to cash from operating activities (the total amount generated from a company’s core business).
Summary
Cash from operating activities (CFO) is a cornerstone of financial analysis, offering a clear lens into a company’s operational health and ability to generate cash from core business activities.
By dissecting its key components – net profit, non-cash adjustments, and working capital changes – investors gain insights into the forces shaping a company’s cash flow. The example of calculating CFO using the indirect method highlights how adjustments bridge the gap between net profit and cash flow.
While profit often grabs the headlines, cash from operating activities quietly answers the more pressing question: Can this company sustain itself?
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