Operating Cash Flow Definition
Operating cash flow or cash flow from operating activities is that part of the cash flow generated by the trading activities of the business. It is basically the net income of the business adjusted for movements in working capital (inventory, accounts receivable, and accounts payable). It represents cash in from selling goods and services less cash out from paying the costs of selling goods and services.
If we look at the basic indirect method cash flow statement below, the highlighted elements represent the main components of Operating Cash Flow of the business.
|Loss on sale of assets||3,000|
|Gain on sale of investments||-4,000|
|Changes in working capital||-5,000|
|Purchase of assets||-45,000|
|Proceeds from the sale of investments||10,000|
|Proceeds from the sale of assets||5,000|
|Issue of new capital||12,000|
|Issue of new debt||26,000|
|Repayment of debt||-8,000|
|Net cash flow||15,000|
|Beginning cash balance||1,000|
|Ending cash balance||16,000|
Net income represents the profit of the business shown in the income statement.
Net income includes a deduction for the expense of depreciation. Although it is an expense in the income statement, depreciation is only an accounting entry to reflect the change in the value of long term assets and does not involve the movement of cash. For this reason it is added back to the net income amount in the cash flow statement.
A similar process is adopted with amortization and depletion.
Gains and Losses
Gains and losses on the sale of assets and investments are bookkeeping entries and do not involve the movement of cash.
For example if an asset is sold for more than its book value, the proceeds from the sale (which includes any gain) are received in cash and included under the cash from investing activities section of the cash flow statement. To avoid double counting the gain which has also been included within net income, it needs to be deducted from net income in the cash from operating activities section of the cash flow statement.
Changes in Working Capital
The purpose of the changes in working capital adjustment is to adjust the net income shown in the income statement of the business from an accruals basis to a cash basis.
The term working capital refers to the net current assets used by the business in it’s normal day to day trading operations. In a simple business it would be calculated as inventory plus accounts receivable minus accounts payable which represents the funding needed to buy inventory and provide credit to customers reduced by the amount of credit obtained from suppliers.
As each element of working capital changes the cash flow changes in the following ways:
- Inventory decreases – Cash in
- Inventory increases – Cash out
- Accounts receivable decreases – Cash in
- Accounts receivable increases – Cash out
- Accounts payable increases – Cash in
- Accounts payable decreases – Cash out
In general the effect of changes in working capital can be summarized as follows.
|Current asset||Cash out||Cash in|
|Current liability||Cash in||Cash out|
Add or Subtract using the Indirect Method
In summary when preparing an indirect method cash flow statement the net income needs to be adjusted for depreciation, gains, losses and movements in working capital. The table below summarizes the necessary adjustments.
|Item||+ / –|
|Decrease in current assets||Add|
|Increase in current assets||Subtract|
|Decrease in current liabilities||Subtract|
|Increase in current liabilities||Add|
Examples of Operating Cash Flow
Examples of cash flow from operating activities include the following:
Operating Cash Inflow
- Cash receipts from the sale of goods and services.
- Cash receipts from royalties, fees, commissions and other revenue.
- Cash receipts from investments, loans and other contracts held for trading purposes.
- Collection of notes receivable.
- Collection of interest income or dividends.
- Cash refunds of income tax, unless identified with financing and investing activities.
Operating Cash Outflow
- Cash payments to suppliers for goods and services.
- Cash payments to employees.
- Cash payments of income tax, unless identified with financing and investing activities.
- Cash payments for investments, loans and other contracts held for trading purposes.
- Interest payments.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.