Cash flow from operating activities (CFO) means the sufficient amount of cash generated from the regular operations of an enterprise to maintain its operational capabilities.
What are the operating activities?
Operating activities are the transactions that enter into the calculation of net income, such as cash receipts from the sale of goods and services, cash receipts from interest and dividend income, and cash payments for inventory.
Operating activities is perhaps the key part of the cash flow statement because it shows whether, and to what extent, business concerns can generate cash from their operations it is these operating cash flows which must, in the end, pay of all cash outflows relating to other activities, i.e. paying loan interest, dividends and so on.
Here are some examples of cash flows from operating activities to understand the basic concept.
- Cash receipts from the sale of goods and the rendering of services
- Cash receipts from royalties, fees, commissions and other revenue
- Cash payments to suppliers for goods and services
- Cash payments to and on behalf of employees
- Cash receipts and payments from contracts held for dealing on trading purposes.
Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included in the determination of net profit or loss. However, the cash flows relating to such transactions are cash flows from investing activities.
How to calculate the net cash flow from operating activities?
Business enterprises are allowed to calculate the net cash flow from operating activities using either (1) Direct Method or (2) Indirect Method.
Under the direct method, the information contained in ‘accounting records’ are used to calculate the cash flow from operating activities. The format shown below can be used.
Calculation of Net Cash Flow from Operating Activities
Example (Direct Method)
From the following calculate net cash flow from operating activities.
All sales and purchases were made on credit during the last quarter of the financial year. Therefore, no cash was paid to creditors or collected from debtors during the year. You are required to calculate cash flow from operating activities by adopting direct method.
Calculation of Net CFO – Direct Method
Under the direct method, the figures required for calculation are obtained from the information supplied by the profit and loss account and the balance sheet. The starting point for calculation will be net profit before taxation. As the net profit ascertained might have been influenced by cash flow activities of all the three categories and also non-cash activities, it needs certain adjustments to be considered for calculating cash flow operating activities. The common items of adjustments are as follows:
(a) Prepaid expenses
Cash inflow from operating activities will increase when there is a decrease in prepaid expenses. In contrast cash flow from operating activities will decrease when there is an increase in prepaid expenses.
(b) Outstanding expenses
There will be a decrease in cash when there is a decrease in outstanding expenses. Similarly, there will be an increase in outstanding expenses.
(c) Interest paid or interest received
Interest paid or received will find a place in the profit and loss account and cause movement of cash. The items need to be adjusted while calculating cash flow from operating activities as they are considered elsewhere in the cash flow statement (say, investing activities or financing activities).
Depreciation on assets is debited to profit and loss account. As it is only a book entry, depreciation does not cause any cash movement and, hence, it should be added back to net profit while calculating cash flow from operating activities.
(e) Profit or loss on sale of fixed assets
Even though the profit or loss on sale of fixed assets is either credited (profit) or debited (loss) to profit and loss account, they do not cause any cash movement. They are only book entries. Therefore, loss on sale of fixed assets should be added back and profit on sale of fixed assets should be deducted from net profit to arrive at cash flow from operating activities.
(f) Stock debtors and bill receivable
A decrease in stock, debtors or B/R will increase the cash inflow from operating activites and an increase in stock, debtors or B/R will decrease the cash inflow from operating activites.
(g) Creditors and bills payable
A decrease in creditors or bills payable will reduce cash and increase in creditors and bills payable will increase cash.
Formula to calculate cash flow from operating activities on the basis of indirect method
Example (Indirect Method)
Calculating net cash flow from operating activities from the following, under indirect method.
1. Profit for the year $15,00,000 after considering the following items.
- Profit on sale of land $18,000
- Depreciation on fixed assets $60,000
- Transfer to general reserves $32,000
- Goodwill written off $20,000
2. The following is the position of current assets and current liabilities on March 31, 2019.
Calculation of Net Cash Flow from Operating Activities (Indirect Method)
Note: * The negative balance of $21,000 should be added to get the net cash flow.