September 09, 2020

Cash Flow from Operating Activities

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Cash Flow from Operating Activities

Company executives are interested in financial security and business stability, which is largely determined by the generated cash flow. In the course of its activities, an enterprise or company generates various cash flows. They can have a different focus – the inflow or outflow of funds, i.e. income or costs. Cash flow is the sum of receipts and payments for a certain period, which is divided into separate intervals. 

Cash flows are used to ensure the functioning of the company in virtually all aspects. To achieve the required business goals and ensure stable growth, the finance manager needs to optimally organize cash flow management. The presence of free cash allows the company to reinvest it or invest in another business in order to get additional profit. For this purpose, it is convenient to classify cash flows into types. One such type is cash flow from operating activities. 

Definition

All cash flows as a result of the operation of the enterprise are divided into three main types: 

  • investment, which is aimed at ensuring the development of the company;
  • operating, which are received from the main activity; 
  • financial, which are based on financial transactions: getting loans, paying off debts, issuing shares, paying dividends. 

Together, they form the Net Cash Flow (NCF) value. Cash flow from operating activities (CFO) is cash that comes from the operating activities of a firm. Operating cash flow is an operating income after deducting operating expenses. After some adjustments, it can be considered as net income. You can find the CFO value using the Cash Flow Statement or using a special formula. 

The income part of the flow from the main activity is only the amount of funds from the proceeds for manufactured products (sales). The cost part includes expenses for organizing production (purchase of raw materials, payment for energy, etc.), staff salaries (sometimes it is shown separately), general expenses (office supplies, rental of premises, utility bills, insurance premiums), advertising budget, repayment of interest on loans and debts, taxes (income, payroll).

Cash Flow from Operating Activities

Why is it important?

This indicator is one of the most important indicators of the company’s success since many obligations are usually paid off at its expense. It characterizes the business even more accurately than the rate of return, since it is not uncommon for a company to make a profit, but not have enough funds to pay the bills. Sometimes this criterion is also used to assess the quality of a firm’s income. Some companies pursue a policy of “aggressive accounting”, when, with high incomes, they have no cash in their accounts. 

Methods for calculating the amount of cash flow

Currently, two main methods that have developed in a world practice are used to prepare reporting documents on cash flows. They differ mainly in the initial characteristics, which are taken as the basis for the calculation.

  • Direct method. It is based on the analysis of the movement of capital in the accounts belonging to the organization. The method clearly demonstrates where the funds come from and where they are spent. It allows you to identify the most costly activities of the enterprise and identify the most profitable activities. When calculating profit using the direct method, some items of expenses are not taken into account: tax deductions, depreciation costs of equipment, fines and penalties, interest on loans, as well as repayment of borrowed funds.
  • Indirect method. It is based on obtaining information that characterizes the main cash flow of the organization for a certain period. The Balance sheet and financial statements are used as a source of information.

The indirect method is used to calculate the net flow. It is convenient for analyzing the company’s economic activities. Since the calculation is based on accounting documents and Balance sheet, the method makes it possible to establish a connection between all the activities the organization is involved in, as well as to see how net profit is formed, and how economic processes affect assets.

Currently, the indirect method is more popular than the direct, mainly due to the simplicity of the calculation. All the necessary data is already contained in the reporting documents, which makes it possible to eliminate errors when working with information. Moreover, the indirect method allows you to track changes in capital turnover and makes it possible to improve the efficiency of the company.

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Author: Charles Lutwidge

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