What are operating activities?
Operating activities are the day‑to‑day functions a business undertakes to produce and deliver its goods or services and to generate revenue. They include the core activities that determine whether a company is profitable and cash‑flow positive—manufacturing, selling, marketing, delivering services, paying employees, and collecting cash from customers. Operating activities are reported on the income statement (operating revenues and operating expenses) and are the main section of the statement of cash flows (cash flows from operating activities). (Source: Investopedia)
The basics of operating activities
– Core vs. non‑core activities: Operating activities are the company’s core, recurring business activities. By contrast, investing activities (buying or selling long‑lived assets or investments) and financing activities (borrowing, repaying debt, issuing or repurchasing equity) support the business but are not its core revenue generators.
– Operating income: Operating income (income from operations) equals operating revenues minus operating expenses (typically COGS, R&D, selling & marketing, general & administrative, depreciation and amortization). It excludes financing costs (interest) and most non‑operating gains or losses.
– Cash vs. accounting profit: Accounting operating income can differ from cash generated by operations because of noncash charges (depreciation, stock‑based comp), timing differences (receivables, payables, inventory), and one‑time items.
Key takeaways
– Operating activities produce the recurring cash flows that reflect the health of a company’s core business.
– Cash flow from operating activities (CFO) is a primary measure investors use to evaluate sustainability of earnings.
– To reconcile net income to CFO, adjust for noncash items and for changes in working capital.
– Positive CFO is preferable to one‑time gains from asset sales or financing activity—investors typically prefer recurring cash generation. (Source: Investopedia)
Operating revenues
– Definition: Revenues earned from selling products or providing services in the ordinary course of business (e.g., sales revenue, service fees).
– What’s included: Sales of the company’s products (whether manufactured in‑house or resold by a retailer), service revenues, and any other amounts that arise from core operations.
– What’s usually excluded: Interest and dividend income are generally not considered core operating revenues unless the company’s business is financial services (banks, insurers, etc.). (Source: Investopedia)
Operating expenses
– Definition: Costs incurred to produce operating revenues and run the business (COGS, labor, materials, advertising, marketing, R&D, G&A).
– Examples: Direct manufacturing costs included in COGS; sales and marketing campaign expenses; rent and utilities; staff payroll and benefits; depreciation and amortization of assets used in operations.
– Noncash items: Depreciation and amortization reduce reported profit but do not immediately use cash—these are added back when computing CFO. (Source: Investopedia)
Operating activities and the cash flow statement
– Structure: The statement of cash flows has three sections: operating activities, investing activities, and financing activities. The operating section reports cash generated or used by the company’s core business.
– Two methods to present operating cash flows:
1) Indirect method (most common): Start with net income, add back noncash expenses (depreciation, amortization, stock‑based comp, impairment losses), subtract noncash gains, and adjust for changes in working capital (accounts receivable, inventory, accounts payable, accrued liabilities).
2) Direct method: Report cash receipts from customers and cash payments to suppliers, employees, etc. (Companies using the direct method usually provide an indirect reconciliation anyway.)
– Typical adjustments (indirect method):
– Add: depreciation, amortization, losses on asset disposals, noncash compensation, deferred tax expense (if noncash)
– Subtract: gains on asset sales, other nonoperating gains
– Working capital: increase in current assets (e.g., accounts receivable, inventory) subtracts from CFO; increase in current liabilities (e.g., accounts payable) adds to CFO.
– GAAP/IFRS nuances: Under U.S. GAAP, interest paid and interest received are generally classified as operating cash flows; under IFRS, entities may classify interest and dividends as operating or investing/financing depending on policy. Check the reporting framework. (Source: Investopedia; GAAP/IFRS practice)
An example of cash flow from operating activities (Apple, fiscal 2017)
Apple reported components that can be combined to estimate cash flow from operations for fiscal year ended September 2017. Using the approach summarized in Investopedia:
– Funds from operations (net income adjusted for noncash items): $69.15 billion
– Net change in working capital: (‑$5.55 billion) (a net increase in working capital that reduced cash)
– Cash flow from operating activities = Funds from operations + (net change in working capital) = $69.15B + (‑$5.55B) = $63.60 billion. (Source: Apple Inc., 2017 Form 10‑K; Investopedia)
Practical steps — how to analyze and compute cash flow from operating activities
1. Choose the presentation (indirect vs direct) you’ll use for your analysis. Most public companies report CFO using the indirect method.
2. Gather three statements: income statement (profit & loss), balance sheet, and statement of cash flows for the period(s) you’re analyzing.
3. Start with net income (from the income statement) if using the indirect method.
4. Add back noncash charges: depreciation, amortization, impairment losses, stock‑based compensation, deferred tax expense (to the extent it’s noncash), and losses on asset disposals.
5. Subtract noncash gains: gains on asset disposals or other one‑time gains included in net income.
6. Adjust for working capital changes (compare current period vs. prior period balance sheet):
– Accounts receivable: increase = subtract from cash; decrease = add to cash.
– Inventory: increase = subtract; decrease = add.
– Accounts payable and accrued liabilities: increase = add to cash; decrease = subtract.
– Other short‑term operating assets and liabilities: apply the same logic.
7. Account for cash taxes and interest per your reporting framework (U.S. GAAP: usually treated as operating cash flows; IFRS: can be classified differently—verify company policy).
8. Sum these adjustments to get cash flow from operating activities. Reconcile to the CFO on the company’s statement of cash flows to ensure you haven’t missed items.
9. Evaluate quality of earnings: compare operating cash flow to net income (cash flow to income ratio). A company earning profits but with persistently negative CFO may be of concern. Conversely, higher CFO than net income can indicate high earnings quality.
10. Check for one‑time or nonrecurring items (large lawsuit settlements, asset sales, tax adjustments) that inflate or deflate operating cash flow—adjust your analysis to focus on recurring operating cash generation.
Key metrics and ratios to monitor
– Operating cash flow (CFO) in absolute terms.
– CFO / Net income (cash conversion ratio): >1 suggests strong cash conversion; <1 may indicate earnings are not being converted to cash.
– Free cash flow (FCF) = CFO − capital expenditures: shows cash available after maintaining/growing asset base.
– Operating cash flow margin = CFO / Revenue: compares cash generation to sales.
– Changes in working capital components trend (AR days, inventory days, AP days): sudden deterioration may signal collection or inventory problems.
Common red flags and pitfalls
– Large, consistent gaps where net income is positive but operating cash flow is negative.
– Rapid increases in accounts receivable or inventory relative to revenue growth (possible revenue recognition or demand issues).
– One‑time cash inflows (asset sales) classified in operating activities (should typically be investing inflows)—check notes.
– Changes in classification policy (e.g., reclassifying interest or dividends) that make trend comparisons difficult—read footnotes.
– Excessive noncash income items (unrealized gains) that inflate net income but not CFO.
Practical example template (indirect method)
1. Net income: X
2. + Depreciation & amortization: Y
3. + Stock‑based compensation, impairment losses, other noncash charges: Z
4. − Gains on asset sales: A
5. ± Changes in working capital (ΔAR, ΔInventory, ΔAP, ΔAccruals, etc.): B
6. = Cash flow from operating activities (CFO)
Where to look for details
– Statement of cash flows (primary source for CFO and reconciliation).
– Notes to financial statements (policy on classification of interest/dividends, components of working capital, nonrecurring items).
– Management discussion & analysis (MD&A) for explanations of working capital movements and one‑time items. (Apple’s 2017 Form 10‑K provides a practical example of this type of disclosure.) (Source: Apple Inc., 2017 10‑K)
Conclusion
Operating activities reveal whether a company’s core business consistently generates cash. For investors and managers, the statement of cash flows—particularly the operating activities section—is essential for assessing earnings quality, liquidity, and the sustainability of growth. Use the indirect or direct method to reconcile accounting profit to cash, watch working capital trends, and adjust for nonrecurring items to get a clear picture of operating cash generation. (Source: Investopedia; Apple 2017 Form 10‑K)
Sources
– Investopedia, “Operating Activities.” (https://www.investopedia.com/terms/o/operating-activities.asp)
– Apple Inc., “2017 Form 10‑K,” Fiscal year ended September 2017 (referenced for example figures).