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Cash flow from operating activities, abbreviated as CFO and otherwise known as Operating Cash Flow (or OCF) is a reliable and globally-accepted indicator of an organisation’s profitability. It is the total income generated by a company while conducting its elementary businesses.

Here, ‘elementary businesses’ refer to a firm’s primary, regular and ongoing business activities.

Some real-life examples will suffice here. Godrej or Usha Lexus specialises in manufacturing furniture, Cognizant and TCS deliver IT/ITeS services and Deloitte and PWC are involved in business consulting.

Understanding CFO Better

Usually, any organisation’s cash flow statement depicts its cash flow from operating activities in its first section. This practice is followed by Chartered Accountants and auditors worldwide.

Note that CFO excludes three crucial sectors of a business’s finances:

  1. Its long-term financial planning and/or strategies.
  2. Revenues likely to be generated by such plans.
  3. Expenses-both in the short and long terms.

Cash flow from operating activities is the undisputed marker of a company’s liquidity and financial strength. It measures how much money (notionally referred to as ‘cash’ here) has entered the firm’s corpus and how much has exited.

It measures the current market situation of that firm’s primary products and services, to give just two examples.

CFO reflects the following metrics in detail:

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  • All accounts receivable and outstanding payments from other entities.
  • The state of the company’s inventory.
  • Changes in cash reserves. These alterations may be negative or positive. A loss-making enterprise may have a negative cash flow.
  • All accounts payable to other entities in the pertinent FY.
  • Depreciation.

Why is Quantifying CFO Essential?

Any company must keep detailed records of their financial activities. These records are mostly made public when quarterly or annual reports are released. Since cash flow from operating activities apportions voluminous information on profits, losses, operational activities, and a brief digest of overall corporate efficiency, computing it is crucial.

Here are three reasons why accountants and C-Suites alike lay great stress on CFO:

  1. It helps figure out untapped but potential areas of business and possible future expansion.
  2. The CFO lays out a summarised roadmap of a business’s core products and services. This roadmap is later pored upon with care to ensure an organisation’s corporate vision is in line with its present business viability.
  3. Finally, CFO elucidates a company’s monetised assets. This helps these firms take important and far-ranging decisions on share buyback/issue, paying dividends and reducing debt incurred on interest payments.

Differentiating CFO and Net Income

There are several misconceptions and misinterpretations related to these two terms. Their chief differences are the following:

CFO (or OCF)Net income
Comprises only of cash inflow and outflow. Non-cash expenses are not included.Includes non-cash expenses and upheavals in working expenditure.
CFO does not factor in amortisation or share-based compensation.Net income takes into account amortisation and any share-bound or share-based compensation.
Companies may have positive cash flow from operating activities while also having a negative net income.Almost every company which has a negative net income but a positive CFO has failed. It is not viable.
CFO only deals with core businesses or interests. Any external factor has no impact.When calculating Net Income, any profits/losses from non-core businesses are considered. This results in a consolidated income statement.

Cash Flow from Operating Activities Format –

There are two formats to determine this type of cash flow – direct and indirect.

Of these, the indirect method is preferred as it uses the ‘accrual method of accounting’. The calculation starts with the net income and then works backwards using this accrual method. Finally, the CFO for a particular period is computed.

The direct method is a bit complicated. As is obvious, such an organisation monitors and notes the inflow and outflow of cash on a regular basis. Salaries and wages, interests and dividends, (whether paid or collected) and miscellaneous cash transactions are recorded in this method.

Both of these methods have differing formulae for precise calculation.

They have been tabulated below.

Formula to calculate cash flow from operating activities direct method
  1. Add all net sales
  2. Add receivables
  3. Subtract all of the receivable assets at the beginning of an FY.
  4. Now, add all ending assets of the FY.
  5. Subtract all beginning assets plus ending payables in a FY.
  6. Now, add only ending payables.
Note: This formula is based on a single FY only. Overlapping FYs and subsequent calculations will have errors.

The second method is the following.

Formula to calculate cash flow from operating activities indirect methodThe ‘shorter’ formula is:

  1. Net Income (plus) Non-Cash Expenses
  2. Subtraction of increase-if any- in Working Capital.

CFO Example – 

Note that both direct and indirect formulas yield identical results.

Let us take Apple Inc.’s financial statements for FY 2017-2018. In that year, this giant corporation had the highest income in almost 10 years.

These reports are available on their official website.

Apple had:

  1. Net income – $59.53 billion
  2. Amortisation + depreciation – $10.9 billion. This section also included depletion but was not expressly mentioned.
  3. Outstanding taxes payable – (-) $32.59 billion. This sum had to be repaid to debtors, including the US Government and other investors.
  4. Miscellaneous funds – $4.9 billion

Following the direct method,

  • Total funds from operations: $42.74 billion.
  • Working capital changed/increased by: $34.69 billion

Upon careful calculation, cash flow from operating activities was $77.43 billion for FY 2017-2018.

Following the indirect method,

  • Net Income and depreciation stood at $59.531 billion and $10.903 billion respectively.
  • Changes In receivables/liabilities/inventories stood at (-) $5.322 billion, $9.131 billion and $0.828 billion respectively.
  • Net income adjustments amounted to (-) $27.694 billion.

Using the indirect method formula, the CFO was the same – $77.43 billion.

Hopefully, it is now clear why precisely calculating cash flow from operating activities is essential for businesses large and small. Note that CFO is not the last word on many corporate decisions. At times, a company’s Board of Directors (BoD) may overturn any decisions arrived from judging CFO.

One such example is Netflix. Even three years ago, it had modest revenues but very humble profits. Their management stood fast, however, despite advice from financial experts.

Now, Netflix is a household name.

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