How does Cash flow from operations differ from other metrics?

Cash flow from operations is an important indicator for companies and investors. It indicates how successful a company is with its core activity. Here we show you how to calculate it and how it differs from other measures.

Cash flow from operations: Meaning

Cash flow from operations is also referred to as cash flow from operating activities. It indicates the amount of money that a company generates from its operating activities. Operating activities are only those activities that are directly related to the production and distribution of the product, or to the provision of a service.

Cash flow from operations is reported in the first section of the cash flow statement. It does not include income from investing activities or expenses not related to operations.

The cash flow from operations is thus an important indicator of how successful a company is with its core business and how it generates its liquid funds from it. A high level of liquidity allows the company to make new investments, expand and offer new products or services. A high incoming cash flow is therefore of great importance for corporate growth.

Cash flow from operations vs free cash flow

Free cash flow is the total cash available before debt is repaid or dividends are paid. It can be calculated from the cash flow from operations by deducting the costs for capital expenditures (CAPEX). Capital expenditures are investments in long-term assets, e.g. the purchase of real estate, land, vehicles or production machinery.

Cash flow from operations vs EBITDA

EBITDA (earnings before interest, taxes, depreciation and amortisation) is very similar to cash flow from operations, but not the same. While cash flow from operations only reflects business activities from the operational area, EBITDA excludes interest and taxes. However, both are taken into account in the operating cash flow, as they are payments.

Cash flow from operations vs net income

Net income is the profit earned by a company within a certain period of time. It is calculated by deducting the costs of goods sold from the turnover. Net income is then used in the second step to calculate the cash flow from operations with the help of the indirect method.

Cash flow from operations: Formula

There are two methods for calculating cash flow from operations: direct and indirect. We will take a closer look at both in the following.

Cash flow from operations: direct method

The direct method compares all income and expenditure as they appear in the bank accounts. In other words, the cash flow is looked at directly. Income and expenditure include, for example:

• Salary payments to employees
• Payments to suppliers
• Revenue from customer payments
• Interest and dividend payments
• Tax payments and tax refunds
• Rent payments
• Expenses for energy, water, etc.

The usual procedure is to offset on a monthly basis the individual income and expenses incurred in the respective month. The result at the end of the month is then either positive or negative. A positive result is called a cash flow surplus; a negative result is called a cash flow deficit.

Cash flow from operations: indirect method

The indirect method is less complex than the direct method, but less accurate. With the indirect method, the cash flow is obtained from the information in the income statement and the balance sheet. The cash flow from operations can be calculated in this way:

Cash flow from operations = Funds from operations + changes in working capital

Funds in operations is calculated using the following variables:

Funds in operations = Net income + depreciation + amortisation + deferred taxes + investment tax credit + other funds

Another way to calculate the cash flow from operations is:

Cash flow from operations = Net income + depreciation + amortisation + adjustments to net income + changes in accounts receivable + changes in accounts payable + changes in inventories + changes in other operating activities

Cash flow from operations ratio

Another key figure is cash flow from operations ratio. It indicates whether the cash generated is sufficient for the company to meet its short-term liabilities. The following formula is used for this purpose:

Cash flow from operations ratio = Cash flow from operations / current liabilities

Current liabilities are all short-term liabilities (term less than 1 year), e.g. payments that the company still has to make to suppliers.

Cash flow from operating activities: Example

A company has the following information on its income statement and balance sheet at the end of the year:

• Net income: £100,000
• Depreciation: £10,000
• Change in inventory: -£30,000
• Change in accounts receivable: £60,000
• Change in accounts payable: -£20,000

This results in:

Cash flow from operations = £100,000 + £10,000 +£30,000 - £60,000 - £20,000 = £60,000

This may seem confusing at first glance because change in inventory and change in accounts receivable are included in the calculation with the opposite sign, but it quickly becomes clear why this is so: a negative change in inventory means that the company has made a sale. This means that it has received money for it, so the value must be added to the cash flow calculation because it has accrued to the company.

The same applies to change in accounts receivable: A positive value here means that the company has made investments (e.g. to purchase goods or materials). This therefore represents an expenditure where money has flowed out of the company. Therefore, this value must be subtracted in the cash flow calculation.

Now you can calculate the cash flow from operations ratio:

Cash flow from operations ratio = Cash flow from operations / change in accounts payable = £60,000 / £20,000 = 3

This means that the company earns £3 from its operations for every £1 of liabilities. It can therefore cover three times its current liabilities with its current cash flow and therefore has a solid cash flow base.