What is cash flow from operating activities (CFO)?
– Cash flow from operating activities (abbreviated CFO, also called operating cash flow or OCF) is the net amount of cash a business produces (or consumes) through its core, day‑to‑day operations during an accounting period. It excludes cash flows from investing (buying/selling long‑lived assets) and financing (issuing debt/equity, dividends) activities.
Why CFO matters (short)
– CFO shows whether the company’s core business generates cash that can fund growth, pay creditors, return cash to owners, or cover expenses. Because accounting profit (net income) uses accruals, CFO provides a cash‑based view of operating performance and liquidity.
Where CFO appears
– CFO is the first section of the cash flow statement, one of the three primary financial statements (income statement, balance sheet, cash flow statement).
Key definitions
– Accrual accounting: revenues and expenses are recorded when earned/incurred, not necessarily when cash changes hands. This creates timing differences between net income and actual cash flows.
– Working capital (operating working capital): current assets and current liabilities tied to operations (examples: accounts receivable, inventory, accounts payable). Changes in these items affect CFO.
– Noncash items: expenses or gains/losses that affect net income but not cash (common example: depreciation; sale gains are accounted in income but the related proceeds appear in investing cash flows).
Two ways to present CFO
1) Indirect method (most commonly used)
– Start with net income and adjust for noncash items and changes in operating working capital to convert accrual profit into cash flow.
– Typical adjustments: add back depreciation & amortization (noncash expense); subtract gains (non‑operating gains included in net income) and add losses; reduce CFO for increases in operating current assets (e.g., accounts receivable) and increase CFO for increases in operating current liabilities (e.g., accounts payable).
Compact formula (indirect):
CFO = Net income
+ Noncash expenses (depreciation, amortization, impairment)
+ Losses (noncash)
− Gains (noncash)
− Increase in operating current assets
+ Decrease in operating current assets
+ Increase in operating current liabilities
− Decrease in operating current liabilities
2) Direct method
– Lists cash receipts and cash payments for operating categories (cash received from customers; cash paid to suppliers, employees, for interest and taxes, etc.). This shows actual cash inflows and outflows rather than adjustments to net income.
– The Financial Accounting Standards Board (FASB) recommends the direct method for clarity, but most companies use the indirect method because it’s easier to prepare from accrual financial statements.
Worked examples
A. Indirect method (small numeric example)
Assumptions for the period:
– Net income = $120,000
– Depreciation expense = $30,000 (noncash)
– Gain on sale of equipment = $10,000 (included in net income but cash proceeds are investing activity)
– Accounts receivable increased by $15,000 (use of cash)
– Inventory decreased by $5,000
Adjustments to reconcile net income to cash provided by operating activities (continue indirect-method example)
Starting point
– Net income: $120,000
Noncash and nonoperating adjustments
– Add back depreciation (a noncash expense): +$30,000
– Subtract gain on sale of equipment (included in net income but is an investing activity): −$10,000
Changes in working capital (current operating assets and liabilities)
– Accounts receivable increased (use of cash): −$15,000
– Inventory decreased (source of cash): +$5,000
Reconciliation calculation
Cash flows from operating activities (indirect method) =
Net income
+ Depreciation
− Gain on sale of equipment
− Increase in accounts receivable
+ Decrease in inventory
Numerically:
$120,000
+ $30,000
− $10,000
− $15,000
+ $5,000
= $130,000
Result: Cash provided by operating activities (CFO) = $130,000
Explanation of each adjustment (short)
– Depreciation: a noncash expense reduces net income but does not reduce cash, so add it back.
– Gain on sale of equipment: increases net income but the cash received is investing activity; remove the gain from operating activity.
– Accounts receivable increase: more revenue is recorded on an accrual basis than cash collected, so cash is lower than net income.
– Inventory decrease: selling inventory without replacing it frees up cash, so add back.
B. Direct method (small numeric example)
Assumptions (direct-method line items)
– Cash received from customers: $300,000
– Cash paid to suppliers: $100,000
– Cash paid to employees: $40,000
– Cash paid for other operating expenses: $15,000
– Interest paid: $5,000
– Income taxes paid: $10,000
Calculation (direct method)
Cash receipts from customers
− Cash paid to suppliers
− Cash paid to employees
− Cash paid for other operating expenses
− Interest paid
− Income taxes paid
= Cash provided by operating activities
Numerically:
$300,000
− $100,000
− $40,000
− $15,000
− $5,000
− $10,000
= $130,000
Note: The direct and indirect methods should produce the same total CFO (both examples yield $130,000). The difference is presentation: the direct method lists cash inflows and outflows; the indirect method starts with net income and adjusts for noncash items and working-capital changes.
Quick checklist
Quick checklist
– Pick a presentation method (direct or indirect). Both yield the same total cash from operating activities (CFO), but the direct method lists cash receipts and payments; the indirect method starts with net income and reconciles to cash by adjusting for noncash items and working-capital changes.
– For the direct method, assemble cash collections from customers and separate cash payments (to suppliers, employees, interest, taxes, and other operating items). Reconcile totals to changes in related balance-sheet accounts (receivables, payables, inventory).
– For the indirect method, start with net income, then:
– Add back noncash expenses such as depreciation and amortization.
– Subtract noncash gains (for example, gain on sale of an asset).
– Adjust for changes in working capital (current assets and current liabilities). Define: working capital changes = changes in accounts that convert to cash within a year (accounts receivable, inventory, prepaid expenses, accounts payable, accrued liabilities).
– Verify classification rules for interest and taxes. Note: under US GAAP, interest paid and received are generally classified as operating activities; under IFRS some interest and dividends can be classified as operating, investing, or financing depending on entity policy—check the reporting framework used.
– Reconcile the CFO total to the change in cash on the statement of cash flows and to the operating section notes or supplementary disclosures.
– Watch for one-off items (large sales of assets, litigation settlements, discontinued operations) that distort operating cash comparisons; reclassify or footnote when appropriate for analysis.
Step-by-step — indirect method (practical)
1. Obtain the income statement and comparative balance sheets (current and prior period).
2. Take net income
2. Take net income and adjust it for non-cash items and non-operating gains/losses
– Add back non-cash expenses that reduced net income but did not use cash:
– Dep
reciation and amortization — add back non-cash charges that reduced net income but did not use cash (depreciation, amortization, impairment charges, stock‑based compensation, unrealized losses classified as operating, the non‑cash portion of deferred tax expense, etc.).
– Subtract non‑operating gains and add back non‑operating losses — remove gains that increased net income but whose cash flows belong in investing or financing (for example, gain on sale of equipment), and add back losses that lowered net income but had no operating cash effect.
– Adjust for changes in working capital (current assets and current liabilities). For each balance-sheet line, determine whether the change from prior period to current period used or provided cash:
– Accounts receivable
– Accounts receivable — an increase in receivables from the prior period means the company made more sales on credit that have not yet been collected, so that change is a use of cash; a decrease in receivables means collections exceeded new credit sales and is a source of cash.
– Inventory — an increase in inventory is a use of cash (the company purchased or produced more goods than it sold); a decrease in inventory is a source of cash (sales or write‑downs freed up cash).
– Prepaid expenses and other current assets — increases in prepaid expenses (or other current assets) consume cash; decreases provide cash.
– Accounts payable — an increase in payables means the company delayed cash payments to suppliers (a source of cash); a decrease is a use of cash (the company paid down its obligations).
– Accrued liabilities (accrued expenses) — increases typically provide cash (expenses recognized but not yet paid), while decreases usually use cash (payments made).
– Deferred revenue (customer deposits) — increases are a source of cash (cash received before revenue recognition); decreases are a use of cash (recognition of previously collected cash as revenue without new cash inflows).
– Other operating current liabilities/assets — treat similarly: determine whether the change indicates cash paid or cash received during the period.
Compact formula (indirect method)
CFO = Net income
+ Non‑cash expenses (e.g., depreciation, amortization, stock‑based comp.)
− Non‑operating gains + Non‑operating losses
− Increases in operating current assets + Decreases in operating current assets
+ Increases in operating current liabilities − Decreases in operating current liabilities
Worked numeric example (indirect method)
Starting data (for a one‑period simplified company):
– Net income = 100
– Depreciation = 15 (non‑cash expense)
– Gain on sale of equipment = 12 (non‑operating gain)
– Accounts receivable: prior = 40, current = 30 (decrease of 10 => source)
– Inventory: prior = 20, current = 28 (increase of 8 => use)
– Accounts payable: prior = 18, current = 25 (increase of 7 => source)
– Accrued expenses: prior = 6, current = 4 (decrease of 2 => use)
Step‑by‑step:
1. Start with net income: 100
2. Add non‑cash expenses: +15 → 115
3. Subtract non‑operating gains: −12 → 103
4. Adjust working capital:
– Accounts receivable decrease (+10) → 113
– Inventory increase (−8) → 105
– Accounts payable increase (+7) → 112
– Accrued expenses decrease (−2) → 110
Result: Cash flow from operating activities = 110
Direct method (brief)
The direct method lists actual cash receipts and cash payments (cash collected from customers, cash paid to suppliers and employees, interest and taxes paid, etc.). It is often clearer about cash origins and uses, but many companies use the indirect method because it ties directly to net income and is easier to prepare from accrual accounting records. Accounting standards allow either method; if the direct method is used, a reconciliation (essentially the indirect method) is still required under U.S. GAAP.
Practical checklist to prepare CFO (indirect)
1. Obtain net income from the income statement.
2. Identify and add back non‑cash charges (depreciation, amortization, stock compensation, impairments).
3. Subtract non‑cash gains and add back non‑cash losses (gains/losses on asset sales, etc.).
4. Compute period‑to‑period changes in operating current assets and liabilities.
5. For each change, decide: does it increase or decrease cash? Apply sign accordingly.
6. Sum adjustments with net income to get CFO.
7. Reconcile any unusual items (one‑time settlements, litigation payments, write‑offs) and disclose.
Common pitfalls and tips
– Don’t mix investing/financing flows into operating items. For example, proceeds from sale of equipment belong in investing, not operating; only the gain/loss adjustment appears in operating when using the indirect method.
– Watch for classification differences across companies: interest paid and received, and dividends received/paid may be classified differently under IFRS vs U.S. GAAP.
– Large non‑recurring items (e.g., restructuring charges) can distort comparability; note them separately.
– Working capital changes can be seasonal—compare several periods or use a rolling average to spot trends.
– For cash conversion analysis, relate CFO to net income, capital expenditures, and free cash flow metrics (CFO − CapEx