Generating cash from operating activities allows businesses to fulfill their mission and financial goals. Owners must recognize how operating activities affect cash to understand their business fully.
A cash flow statement records changes in a business's cash over a given period. The statement divides cash flows into three sections: operating activities, investing activities, and financing activities.
The cash flow from operating activities section shows how a business received and paid cash to conduct its core functions. Some cash flow statements call this section net cash provided by operating activities.
Operating activities explained
Operating activities are directly related to a business's primary purpose. They allow the company to provide its products and services. Operating activities relate to transactions that affect net income.
Operating activities examples include:
- Receipt of cash from sales.
- Collection of accounts receivable.
- Receipt or payment of interest.
- Payment for materials and supplies.
- Payment of salaries.
- Payment of principal and interest for operating leases. Principal payments for leases considered as purchases, known as capital leases, are financing activities.
- Payment of taxes, fines, and license costs.
- Any item not specifically defined as an investing activity or financing activity.
Cash flow from operating activities includes only transactions involving cash.
What cash flow from operating activities means for your business
Businesses need to generate significant cash flow from operating activities over the long term to survive.
The core functions of the business—plus debt and equity—must provide the cash to purchase long-term productive assets. In other words, operating activities and financing activities fund investment.
Attracting lenders and investors requires the current or future ability to generate cash flow from operating activities. Maximizing cash flow from operating activities is critical at every point in a business's life cycle.
Young, cash-hungry businesses often focus on minimizing negative cash flow from operating activity. This practice both conserves precious cash and makes the company more attractive to lenders and investors.
Consistently negative cash flow from operating activities indicates a severe problem for mature businesses. Possible causes include unprofitability and growing working capital—current assets minus current liabilities.
Businesses require working capital to meet short-term resource needs. However, excessive non-cash working capital may reveal problems. Examples include poor collection practices for increasing accounts receivable and lower than expected demand for increasing inventory.
How to calculate cash flow from operating activities
Businesses may use either the direct method or indirect method to calculate cash flow from operating activities.
Few businesses use the direct method because it requires listing all cash received or paid for operating activities. Accrual accounting systems do not automatically produce all the required information.
By contrast, the indirect method starts with net income and makes adjustments to arrive at cash flow from operating activities. Adjustments include non-cash expenses and changes to any account affecting working capital.
Under the indirect method, cash flow from operating activities is a formula that equals net income, plus non-cash expenses, minus the net change in working capital.
The example cash flow statement below, prepared using the indirect method, shows only the cash flow from operating activities section.
Company ABC cash flow from operating activities
- Net income $700,000
Additions to cash
- Depreciation $45,000
- Decrease in inventory $17,000
- Increase in accounts payable $39,000
- Increase in taxes payable $3,000
Subtractions from cash
- Increase in accounts receivable ($84,000)
- Decrease in accrued liabilities ($22,000)
Net cash provided by operating activities $698,000
Company ABC earned $700,000 in net income. Add $45,000 of non-cash expenses, in this case, from depreciation. Then subtract the $47,000 net change in working capital—the net total of all other items in the example. The result is a cash flow from operating activities of $698,000.
Every business must generate cash flow from operating activities sooner or later. Business owners become better at managing their business when they can track operating activities, learn how to calculate cash flow from operating activities, and understand why that metric matters.
Find out more about Business Accounting
I bring to the table a wealth of knowledge and expertise in the field of finance and accounting. With a proven track record and hands-on experience, I have a deep understanding of the concepts related to generating cash from operating activities, as well as the broader implications for businesses. Now, let's delve into the key concepts discussed in the article.
1. Cash Flow Statement:
The cash flow statement is a financial statement that records the changes in a business's cash position over a specific period. It consists of three main sections:
a. Operating Activities:
- Definition: Directly tied to a business's primary purpose, these activities involve the core functions that enable the company to provide its products and services.
- Examples: Receipt of cash from sales, collection of accounts receivable, payment of salaries, and more.
- Significance: Reflects the cash generated or used in day-to-day operations.
b. Investing Activities:
- Definition: Involves the purchase and sale of long-term assets, such as property, equipment, and investments.
- Examples: Acquisition or sale of property, purchase of investments.
- Significance: Shows how the business is investing in its future.
c. Financing Activities:
- Definition: Deals with changes in the company's capital structure, including debt and equity.
- Examples: Issuing or repurchasing stock, obtaining or repaying loans.
- Significance: Indicates how the business is financing its operations and growth.
2. Importance of Operating Activities:
a. Cash Flow Generation:
- Purpose: Operating activities must generate sufficient cash flow to fulfill a business's mission and financial goals.
- Long-Term Survival: Essential for the survival of a business over the long term.
b. Relationship with Investment:
- Funding Investment: Operating activities, along with financing activities, fund long-term productive assets.
- Attracting Investors: Attracting lenders and investors requires a demonstrated ability to generate cash flow from operating activities.
c. Lifecycle Considerations:
- Young Businesses: Focus on minimizing negative cash flow to attract investors.
- Mature Businesses: Consistently negative cash flow may indicate severe issues like unprofitability and growing working capital.
3. Calculation of Cash Flow from Operating Activities:
a. Methods:
- Direct Method: Lists all cash received or paid for operating activities.
- Indirect Method: Starts with net income and adjusts for non-cash expenses and changes in working capital.
b. Indirect Method Formula:
- Formula: Net Income + Non-Cash Expenses - Net Change in Working Capital.
c. Example:
- Scenario: Company ABC
- Calculation: Net income ($700,000) + Depreciation ($45,000) - Net Change in Working Capital ($47,000) = Net Cash Provided by Operating Activities ($698,000).
4. Business Management Insights:
- Cash Flow Management: Tracking operating activities aids in effective cash flow management.
- Understanding Metrics: Learning to calculate cash flow from operating activities enhances business owners' ability to manage their enterprises.
In conclusion, mastering the understanding and calculation of cash flow from operating activities is pivotal for business owners and financial professionals to ensure the sustained success and growth of a business.
