All You Need To Know About Cash Flow from Operating Activities (CFO)

What is Cash Flow from Operating Activities (CFO)?

Cash flow is one of the most critical parts of a business. It represents how much cash inflow and outflow occurred in the business during a specific time period, which is generally a quarter or a year. It helps key stakeholders in keeping an eye on the sources and applications of funds, which in turn helps them to streamline their cash flow to sustain the core business operations.

The cash that a business generates through its core operations is known as Cash Flow from Operating Activities (CFO). These activities include manufacturing, selling, and even providing service to consumers. Maintaining vigilance over the operating cash flow aids in making the right management decisions.

Since this strictly includes only operating expenses, long-term capital investments and other financial expenses are not considered as a part of cash flow from operating activities.

Types of Cash Flow from Operating Activities

After understanding the cash flow from operating activities meaning, let us also understand that there are two ways in which Cash Flow from Operating Activities can be depicted in a Cash Flow Statement:

Indirect Method

In this case, the firm takes net income as its starting point and refers to the changes in the balance sheet to add or subtract amounts in the Cash Flow from Operating Activities. This is called ‘accrual accounting,’ wherein the receipt of money is recorded as soon as the transaction occurs. This is even before the cash is actually received. This method allows for the listing down of all cash flows including those expected in the future. This presents a more accurate picture to the reader of the Cash Flow Statement.

Let’s understand this through an example. Assume that you are buying an air conditioner that costs ₹35,000. Now instead of cash you choose to pay by credit card, which means that the seller will not receive the money upfront. However, in the ‘indirect’ or ‘accrual’ method, the seller will still record this transaction and add it to the net income in the P&L Statement (or Income Statement).

Against the income, the Cash Flow Statement will register this as a reduction in Working Capital as inventory goes out from the seller’s end. As we mentioned earlier, this ₹35,000 will also appear in the Balance Sheet of the seller as a part of Accounts Receivable.

Direct Method

In this method, the transactions are recorded on a cash basis. This means it appears under Cash Flow from Operating Activities only after the due amount is received by the business. This means that their Cash Flow Statement does not reflect any future cash flows and only takes into account those that were received or handed out in that period. This also implies that modifications to the net income are not required in this method. However, most companies prefer the indirect method of accounting.

Indirect Method vs Direct Method for CFO Calculation

There are two major differences between these methods:

• In the indirect method, all transactions are noted irrespective of whether the cash payment has been received or not and thus, includes even the future cash flows. This allows the management to view the cash flow situation as a whole and not just a part of it.

Conversely, the direct method advocates only the jotting down of cash transactions only after the payments have been received. Thus, they offer a very narrow picture of the cash flow situation of a company.

• In the indirect method, the base of the calculation is the net income, which is then adjusted basis the line items from the Balance Sheet. The adjustments are required because even non-cash transactions are included in Cash Flow from Operating Activities.

On the other hand, computation using the direct method does not require any adjustments as it simply jots down the cash flows as and when they occur. It ignores all non-cash transactions and does not include future cash flows at all.

Example of Cash Flow from Operating Activities

Information Available:

In a company’s income statement, sales were ₹6,60,000; gross profit of ₹3,55,000; selling and administrative costs of ₹1,55,000; and income taxes of ₹50,000. The selling and administrative expenses included ₹15,000 for depreciation.

Calculation:

Step 1: Using the indirect method, we first need the net income, so we will first prepare an income statement. From the available information, here’s how the Income Statement will look:

Step 2: We need to add the non-cash expense which is depreciation of ₹15,000.

Step 3: Now let’s calculate the changes in operating accounts.

• Change in Accounts Receivable = 70,000 – 86,000 = -16,000 (cash outflow)
• Change in Inventory = 60,000 – 47,000 = 13,000 (cash inflow)
• Change in Accounts Payable = 50,000 – 43,000 = 7,000 (cash inflow)

Step 4: Cash Flow from Operating Activities = 1,50,000 -16,000 + 13,000 – 7,000 + 15,000 = ₹1,55,000

Conclusion

Cash Flow from Operating Activities is a very good indicator of a company’s operating performance. Investors can ascertain whether the core business operations are creating adequate cash flow or not and make informed investment decisions. If the Cash Flow from Operating Activities is insufficient, it is a red flag and the company likely will not be able to sustain itself in the long run.