Cash Flow from Operations

Cash flow from operations (CFO) represents the net cash flow of a company from its core operating activities. It can be calculated using either the direct method which finds out actual receipts from customer and payments to suppliers and others, or the indirect method which adjusts net income to arrive at net cash flow from operations.

Because a company’s value is theoretically equal to the present value of its cash generating potential and because accounting income is sensitive to management’s discretion in some of the accounting policies and estimates, cash flows from operations is a better indicator of a company’s true performance. Many financial ratios are based on cash flow measures of income such as price to cash flow ratio, debt coverage ratio, etc. Some of the most popular company valuation models are based on cash flow measure such as free cash flow model which values a company at the present value of its free cash flows which is a cash flow measure derived from cash flows from operations.

Formula

We can work out the cash flow from operations using two methods: (a) the direct method and (b) the indirect method.

In the direct method, we find out actual cash received from customers and cash paid to employees, suppliers and for other operating expenses and we subtract the outflows from the inflows to arrive at the net cash flow.

In the indirect method, we adjust the net income figure as reported on an income statement for non-cash items and changes in working capital. The following template can be used to work out cash flows from operations using the indirect method:

Example

Work out the cash flows form operations for Company ABC whose balance sheet is given below:

USD in million 31-Dec-17 31-Dec-16
Assets
Non-current assets
PPE 110 100
Intangible assets 42 40
Long-term investments 72 53
Current Assets
Inventories 15 10
Accounts receivable 20 25
Cash and bank 10 25
Total assets 269 253
Equity
Common stock 30 20
Additional paid-up capital 45 30
Retained earnings 40 20
Non-current liabilities
Long-term debt 80 90
Current liabilities
Accounts payable 40 50
Accrued expenses 12 18
Taxes payable 10 15
Interest payable 12 10
Total equity and liabilities 269 253

Following is the income statement:

Income statement USD in million
Sales 300
Cost of sales (200)
Gross profit 100
Selling expenses (20)
G&A expenses (15)
EBIT 65
Interest expense (10)
EBT 55
Taxes (20)
Net income 35

During the year, depreciation expense and amortization expense amounted to $20 million and $3 million. Taxes paid, interest paid, and dividend paid amounted to $25 million, $8 million and $15 million.

Under the direct method, net cash flow from operations equal revenue receipts minus payment to suppliers and payments for other operating expense.

Receipts from customers equal opening accounts receivable balance plus sales minus closing accounts receivable balance. In this case, total receipts are $305 million:

Revenue receipts USD in million
Opening accounts receivable balance 25
Sales 300
Closing accounts receivable balance (20)
Receipts from customers 305

To calculate payment to suppliers, we first need to calculate inventories purchased which equal closing inventories balance plus cost of sales (net of any depreciation and amortization) minus opening inventories balance. Next, we need to find payments to suppliers which equal inventories purchased plus opening accounts payable minus closing accounts payable. In our example above, total payment to suppliers work out to $192 million.

Payment to suppliers USD in million
Cost of sales ($200 million - $20 million - $3 million) 177
Add: closing inventories 15
Less: opening inventories (10)
= Inventories purchased 182
Add: opening accounts payable 50
Less: closing accounts payable (40)
Payment to suppliers 192

We can club the rest of the operating expenses with operating current assets and current liabilities to arrive at the net payment for operating expense. The general formula would be as follows:

$$ CF (Opex)=OPEX+OL+CA-CL-OA $$

Where CF(Opex) is the cash paid for operating expenses, OPEX is operating expenses (sum of selling expenses and G&A expenses in the example above), OL is opening operating liabilities balance, CA is closing operating assets balance, CL is closing operating liabilities balance and OA is opening operating assets balance. In the example above, cash paid for operating expenses (other than cash paid to suppliers) works out to $41 million as shown below:

Cash flow for operating expenses USD in million
Selling expense 20
G&A expenses 15
Opening accrued expenses 18
Closing accrued expenses (12)
Payment to employees and others 41

Using the cash receipts and cash payments worked out above we can determine the cash flows from operations using the direct method as follows:

Cash flows from operations: direct method USD in million
Revenue receipts 305
Payment to suppliers (192)
Payment to employee and others (41)
Taxes paid (25)
Cash flows from operations 47

Indirect method

Calculating the cash flows from indirect method is easier. We just need to add the non-cash expenses such as depreciation and amortization and loss on sale of fixed assets, etc. and non-operating expenses to net income, subtract non-cash gains and incomes, adjust for changes in working capital (i.e. add decrease in assets and increase in liabilities to net income and subtract increase in assets and decrease in liabilities) and subtract taxes.

The following schedules calculates cash flow from operations using the indirect method:

Cash flows from operations: indirect method USD in million
Net income 35
Add: interest expense 10
Add: tax expense 20
Add: depreciation and amortization expense 23
Decrease in accounts receivables 5
Increase in inventories (5)
Decrease in accounts payable (10)
Decrease in accrued expenses (6)
Taxes paid (25)
Cash flows from operations 47

Written by Obaidullah Jan, ACA, CFA and last modified on