Importance of Cash Flow From Operating Activities

Understanding Cash Flow from Operating Activities

CFO is the base of analysing a company’s financial health. Explore its importance and how to analyse it.

Cash flow from operating activities (CFO) is a measure that tells us the amount of cash a company generates through its everyday business operations and how much money goes out of the business. This metric is crucial for investors as, with this insight, you can analyse the income sources of a company and how effectively they manage its core activities. 

A Gist About The Cash Flow Statement

The cash flow statement is divided into three main parts, each providing valuable insights into a company’s financial activities.

1. Operating Activities: This section focuses on the cash flow generated or used in the company’s core operations such as product sales. It includes revenue from sales, expenses related to marketing, manufacturing, technology, resource allocation (such as hiring employees or purchasing equipment) and others. Operating cash flow includes all the cash the company earns and spends. 

Analysing cash flow from operations is relatively simple. If the company has a negative operating cash flow, it does not have sufficient funds to keep its business going. On the other hand, a consistent increase in cash flow from operations is a good sign. 

2. Cash From Investing Activities: The cash flow from investing activities includes the company’s investments, sales of assets, and interest received. These are long-term assets or upgrades to existing assets. For example, investing in land or property, machines, intangible or non-current assets, etc.

3. Cash From Financing Activities: This part of the cash flow statement highlights the company’s financial activities. It includes cash flow related to raising capital or repaying debts. Examples of financing activities include paying dividends to shareholders, paying interest on debt, issuing corporate bonds, or obtaining new loans.

By analysing these three components of the cash flow statement, investors and analysts can understand how a company generates and utilises its cash, providing valuable insights into its financial health and stability.

Today, we are focusing on the first segment of the Cash Flow Statement: Cash Flow from Operating Activities (CFO)

Understanding Cash Flow from Operations With an Example

Cash flow from operating activities reflects a company’s ability to generate cash through its core business operations. To better understand operational activities, let’s consider an example. Imagine a shopkeeper who sells mobile phones:

  • When the shopkeeper sells a mobile phone and receives payment in cash or digitally, it is considered an operational activity.
  • If the shopkeeper pays a salary to an employee working in the shop, this expense is also categorised as an operational activity.
  • When the shopkeeper purchases mobile phones from suppliers, he pays the supplier. This transaction is part of operational activities.
  • If the shopkeeper lends money to a customer and receives repayment in cash or digital form, it is also considered an operational activity.

Things Not Included in Cash Flow from Operations

  • Cash flows related to investments in assets such as property, plant, and equipment and cash flows from financing activities like issuing or repurchasing shares, paying dividends, or obtaining and repaying loans, are not part of the cash flow from operations.
  • Non-cash items such as depreciation, amortisation, and changes in the fair value of financial instruments are not considered in the cash flow from operations. 
  • Changes in working capital are not included, which comprises current assets (such as inventory and accounts receivable) and current liabilities (such as accounts payable and accrued expenses). 

Calculating Cash Flow from Operations

Direct Method

The direct method of calculating cash flow from operating activities involves recording all transactions on a cash basis, using actual cash inflows and outflows during the accounting period. Examples of transactions included in the direct method are wages paid to employees, cash payments to vendors and suppliers, cash collected from customers, interest income, dividends received, and payments of income tax and interest.

Indirect Method

The indirect method starts with the net income figure and adjusts it to derive the final cash flow from operating activities. This method requires making adjustments for non-cash items, such as amortisation and depreciation, to reflect the actual cash flow. Additionally, changes in working capital, including accounts receivable, accounts payable, and inventory, need to be considered in the calculation.

Cash flow from operating activities is essential as it provides insights into the success or failure of a company’s core business operations. A positive cash flow from operating activities indicates the company’s ability to fund growth initiatives, introduce new products, distribute dividends, and reduce debt. It is a crucial metric for investors and stakeholders in assessing a business’s financial health and sustainability.

In conclusion, by analysing the cash flow statement alongside the income statement and balance sheet, investors can obtain a clearer picture of the company’s actual profitability. 

Understanding and analysing operating cash flow helps investors make informed decisions and assess a company’s financial health and sustainability in the long run.

*Article is for informational purposes only. This is not investment advice.


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