Cash Flow from Operating Activities and How to Calculate it
The cash flow statement is one of the most common reports included in any financial plan.
It provides a detailed look at the movement of cash in and out of your business and is essential for staying afloat and planning future investments.
Cash flow from operating activities is a section of a cash flow statement that gives an indication of a businesses health.
In this article, we’ll break it down to understand why and how.
There are a few nuances that can be tricky to get your head around, so let’s start at the beginning.
What is cash flow from operating activities?
Cash flow statements all come in different shapes and sizes. A common format is to divide it into 3 sections – operating activities, financing activities and investing activities – then further break down these sections into different categories.
The first section, cash flow from operating activities, represents cash from the company’s day to day activities, what it sells, buys, the bills it pays, salaries, etc. It can also include the interest the business pays on loans.
This section is a great indicator of how your business is performing. Analysing this area reveals how well your income is covering your primary costs, free of external funding sources. If cash from funding sources were included here, it might hide poor business performance and make decision making more difficult.
Any activity not part of the day to day operations are split away into the other sections. This means that cash impacts such as asset purchases (investing activity), debt drawdown and taxation (financing activity) don’t affect it. It gives you a clean total at the bottom of your operating activities section that is a true reflection of business performance.
You can break down cash flow from operating activities even further, by product lines or cost types. Companies will typically create a cash flow forecast by estimating these individual categories.
As you track your actual performance over time, these extra categories will highlight the areas of the business that are successfully bringing in cash or are draining more cash than expected.
How do you calculate cash flow from operating activities?
There are two methods of calculating cash flow from operating activities on the cash flow report: The direct method and the indirect method.
It is usually only this section of the cash flow statement that can be calculated using either the direct or indirect method.
The Direct Method
The direct method draws its data from actual cash transactions: bills paid, income from certain products or services, salaries etc.
It tracks all cash transactions in and out of the business to leave you with your net cash from operating activities.
The Indirect Method
The indirect method starts with the business’ net profit from the profit & loss statement.
This is then adjusted to remove items that appear on the Profit & Loss but do not affect cash, to give a net cash amount.
A simple example is depreciation, which is a loss to the business but does not have a knock-on effect on cash.
But which method should you use?
Each method offers benefits and drawbacks, but they will both ultimately arrive at the same bottom figure.
The direct method is more useful for making decisions about your future cash flow. Since it clearly shows the direct sources responsible for cash movements, it’s easier to judge the actions you need to take surrounding those business activities.
This means that the direct method usually leads to a clearer picture because you can see exactly how you have arrived at that figure.
The drawback to the direct method is that it can be harder to create depending on how you hold your accounting data. Many online accounting apps prioritise ordering your performance by a Profit & Loss statement which isn’t cash based.
This is where the indirect method comes in. The indirect method starts with the bottom line of your Profit & Loss and then adjusts it for non-cash movements. It’s a good way for understanding why your profit for a period differs from your cash but it’s less useful for making decisions around cash flow.
See the example below to see which method produces a clearer picture of cash origins:
Cash Flow Statement – Direct Method Cash Flow Example:
Cash Received from customers £3000
Cash Paid to Suppliers (£800)
Employee Costs Paid (£1200)
Interest Paid (£100)
Net Cash from Operating Activities £900
Cash Flow Statement – Indirect Method Cash Flow Example:
Net Income £1100
Adjustment: Depreciation £100
Adjustment: Accounts Payable £150
Adjustment: Accounts Receivable (£200)
Adjustment: Inventory (£250)
Net Cash from Operating Activities £900
You can see exactly where the money is coming from in the direct method, making it invaluable for forecasting, where the bigger picture leads to better decision making.
How does cash flow from operating activities differ from financing and investing activities?
We know already that cash flow from operating activities represents cash from the company’s day to day activities. Let’s see what the other two sections from your cash flow statement are about.
What are investing activities?
Cash flow from investing activities represents cash from the businesses actions that involve investing, such as the initial purchases and costs involved in the opening of a new store in a retail business.
What are financing activities?
Cash flow from financing activities represents the cash that comes from debts, loans injections of cash from the business owner and/or equity.
What do the differences say about my business?
Every thriving or surviving business has a positive bank position at the bottom of their cash flow statement.
It’s the composition of operating, financing and investing activities that really demonstrates what stage a business is at. Forecasting the changes in these sections shows where they are going.
If the total of operating activities is negative it means their sales aren’t covering their running costs. For the closing bank position at the bottom to be positive it means that financing activities will have to be positive to make up the difference. I.e they are borrowing money.
Negative operating activities example:
Total of operating activities (£5000)
Total of investing activities £0
Total of funding activities £8000
Net cash flows: £3000
The cash flow for a business in this state is either a startup and doesn’t yet have strong sales or an existing business that is going through a rough period (or perhaps a business with highly seasonal sales).
A business might create a cash flow forecast to show how they can move from being reliant on financing activities for a positive bank position to the position of operating activities being sufficient.
A startup might also show a large negative position in investing activities too, since they may have a lot of initial set up costs and one-off spending. Any business investing in their growth might be taking surplus cash from previous periods and investing it back into the business.
This story would be revealed on the cash flow statement by positive operating activities and negative investing activities. Their strong operations are fueling investment into future growth.
Negative investing activities example:
Total of operating activities £12000
Total of investing activities (£10000)
Total of funding activities £0
Net cash flows: £2000
These are simplified examples that show how the different parts of the cash flow interact and work to clearly show what the business is up to.
Ultimately, every business wants to end up with positive operating activities. This shows the business can support its own operations.
If operating activities are not positive right now, then a business needs a plan for how the business will stay afloat in the short term and a long term plan for how they will operate in a cash positive way.
Final thoughts
Here’s what we’ve learnt:
- Cash flow from operating activities is the first section on the all-important cash flow report and covers cash generated or spent from day-to-day activities such as sales, purchasing inventory and paying salaries
- There are two methods of calculating it:
- Direct method – derived from cash transactions, top-down approach. Time-consuming, but clearer end picture of cash origins.
- Indirect method – bottom-up approach, starting with net income and working backwards. Less time-consuming but lacks accuracy.
- Drawing differences between operating, investing and financing activities shows the importance of operating activities and how forecasting it provides you with valuable information to analyse and make better business decisions.
At first, this can all seem a little tricky to get your head around, but hopefully today we’ve helped you get on your way to better understanding the cash flow statement.
Remember, fully understanding and forecasting the cash flow statement is one of the keys to better decisions and ultimately important for a businesses survival – looking at it alongside the profit and loss & balance sheet reports are even more important.
