Cash Flow From Operating Activities: A Comprehensive Guide

You might have encountered cash flow from operating activities on your business cash flow statement. We’re breaking down the calculation so you can see what factors play the biggest role.

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What is Cash Flow from Operating Activities?

According to Investopedia, cash flow from operating activities (CFO) is an accounting item that indicates the amount of money a company brings in from ongoing, regular business activities, such as manufacturing and selling goods or providing a service.

This calculation, also known as operating cash flow (OCF), makes up one of three sections of a company’s cash flow statement. Its purpose is to show how much capital the business can generate simply from day-to-day operations, rather than through fundraising, borrowing, or other external financing.

Breakdown

Here’s the formula used to calculate your business’s OCF:

OCF = Net income + Depreciation/Amortization + Changes in Working Capital

With that in mind, let’s break each key element down.

Net Income

The net income, or revenue, is usually taken directly from the top line of your company’s income statement. All the sales coming in are used as a baseline to which adjustments are made in order to determine cash flow.

Depreciation and Amortization

The next step is to incorporate depreciation and amortization. These are tangible assets like large equipment and intangible assets like licenses that are listed as expenses on your income statement, but are actually added back into your revenue since they’re not cash-based.

Changes in Working Capital

The final step of the equation is to incorporate differences in working capital over time. If assets outweigh liabilities, you’ll see a positive number. Otherwise, it’ll be subtracted from your overall cash flow. For example, if you see an increase in accounts receivable, the capital owed to you by your customers, this will have a negative impact on your cash flow. On the other hand, an increase in accounts payable (the money your company owes) means that you have more available cash and therefore a higher OCF.

Cash Flow from Operations Example

Let’s say that your company’s net income for 2020 was $10,000. If you also have $1,000 in depreciation or amortization value, $4,000 in inventory (an asset) and $2,000 in liabilities, then your OCF would be:

OCF = $10,000 + $1,000 + ($4,000 - $2,000) = $13,000.

The subtraction in parentheses represents the use of assets and liabilities to calculate your changes in working capital. Later, we’ll show you how to account for these factors in the operating activities section of your cash flow statement.

When to Use Cash Flow from Operating Activities

In theory, any time you are generating your company’s cash flow statements, you should use OCF. However, OCF can be complicated to calculate (we’ll explain the complexities later). As such, you can get away with creating a relatively top-level cash flow statement if you want to get a quick snapshot of your instantaneous cash items. If you’re instead trying to analyze all your cash-generating activities during a period, you’ll need OCF.

Whether or not you use OCF, only cash flow statements, rather than a balance sheet or income statement, can tell you how much cash you have immediately available for business expenses. Although a balance sheet shows the value of all your assets and an income statement shows your past financial performance, cash flow statements indicate the cash you actually have.

Cash Flow from Operating Activities vs. Net Income

In small business affairs, net income is often viewed as more meaningful than the amount of cash your company has on hand. However, the cash your company generates can be significantly larger or smaller than net income.

That’s because you’ve likely calculated your company’s net income at least partially based on expenses for which you haven’t spent cash. That’s why the OCF equation requires you to add depreciation and amortization back to your net income. You’ll never actually spend money to cover these costs, but the decreasing asset values they represent theoretically lower your company’s bottom line. In reality, these are not cash expenses, and OCF reflects this distinction.

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Cash Flow from Operating Activities: Calculation Methods

The aforementioned OCF equation represents the indirect method of calculating OCF. A direct method also exists. We’ll explain both below.

Direct OCF

For the direct OCF method, you’ll add all your company’s cash received and subtract all your cash paid. To do so, set a start date and end date for all your cash accounts, then find the difference between the accounts’ values at these dates. Given these guidelines, a simple direct OCF calculation might appear as such:

Direct OCF = $10,000 earnings from clients - $2,000 in vendor payments - $6,000 in wages = $2,000.

Notably, direct OCF does not explicitly include net income in its equation, so you’ll need to reconcile your OCF for net income.

Indirect OCF

If you use the indirect method to determine your cash flow, then you’ll have to add and subtract every single instance of your cash receipts or spending. This approach will theoretically yield the same OCF as the direct method, but its calculations are far more complex. An equation for the indirect method of calculating OCF might look as follows:

Net Income + Depreciation + Stock Based Compensation + Deferred Tax + Other Non Cash Items

– Increase in Accounts Receivable – Increase in Inventory

+ Increase in Accounts Payable + Increase in Accrued Expenses + Increase in Deferred Revenue

= OCF

Clearly, the indirect method involves far more variables than the direct method. However, in the cash flow statement example we give below, you’ll see that the cash flow statement’s table format can make indirect OCF calculation far easier than it first appears.

Example of Cash Flow From Operating Activities on the Cash Flow Statement

Given the above indirect OCF equation, a cash flow statement might appear as follows:

Your Company
Cash Flow Statement 2021

Net income
Depreciation and amortization
Stock-based compensation
Deferred taxes
Other non-cash expenses
Increase in accounts receivable
Increase in inventory
Increase in accounts payable
Increase in accrued expenses
Increase in deferred revenue
OCF
Investing activities
Financing activities
Total cash equivalents
10,000.00
2,000.00
500.00
100.00
500.00
(2,000.00)
(6,000.00)
500.00
100.00
1,000.00
6,700.00
(3,000.00)
2,000.00
5,700.00

Note that the total cash equivalents value in the final row arrives after subtracting investment and financing operations (collectively known as your capital expenditures) from your OCF. This final value is called free cash flow (FCF), and it often gives a better depiction of your available cash than does your OCF.

Why It Matters

Cash flow from operating activities matters for the following reasons:

  • Funding access. Lenders want to know how much cash your company has on hand to grow and accommodate a loan.
  • Better understanding of your finances. Cash flow statements allow you to get an understanding of not only your net income, but how it figures in your available revenue on a regular basis.
  • Better understanding your company’s long-term financial health. A company facing cash flow issues at any moment could fail in the long term. OCF calculations can pinpoint areas in which your company can reduce spending or boost revenue and thus remain stable in both good and bad times.
  • Planning for investing and financing. As mentioned above, investing and financing don’t factor into OCF. Instead, your OCF value tells you how much cash you have available for these activities, both of which can help you grow your company.
  • Stakeholder satisfaction. Your stakeholders will want to know how much they could earn from your business if they sell their shares. OCF can answer this question while helping your stakeholders suggest ways to invest in and finance your company.

Understanding the components that make up your business cash flow can help you strengthen your bottom line, lower expenses, and increase efficiency. With strong cash flow, you may also be eligible for low-cost financing like an SBA loan. Known as the gold standard in small business lending, SBA loans have low rates, long terms, and no prepayment penalty. SmartBiz Loans will be your advocate and help you get to a “Yes” with a streamlined application process. See how we’ve helped small business borrowers like you by visiting our TrustPilot profile.

Learn where you stand in terms of being Loan Ready by signing up for SmartBiz Advisor today. You’ll get personalized recommendations based on your financial situation that can help you build a strong lending profile and increase your chances of loan approval, free of charge.

* The information provided through SmartBiz Advisor, including the Loan Ready Score, is for educational purposes and is not the same as scores used by lenders for credit decisions. SmartBiz Advisor is not a financial or legal advisor as defined under federal or state law. Use of this information is not a replacement for personal, professional advice or assistance regarding your finances or credit history.

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