Cash Flow from Operations (CFO)

Cash Flow from Operating Activities Formula

The “Cash Flow from Operations” is the first section of the cash flow statement, with net income from the income statement flowing in as the first line item.

Starting from net income, non-cash expenses like depreciation and amortization (D&A) are added back and then changes in net working capital (NWC) are accounted for.

Cash from Operations: Non-Cash Expense Adjustments (D&A)

Non-cash add-backs increase cash flow as they are not actual outflows of cash, but rather accounting conventions.

For instance, depreciation is the allocation of capital expenditures (CapEx) across the purchased asset’s useful life assumption, which is done to abide by the matching principle (i.e. expenses are matched with corresponding benefits).

Typically, D&A is embedded within COGS/OpEx on the income statement, which reduces taxable income and thus net income.

Since net income represents the profits under accrual accounting, the CFS adjusts the net income value to assess the true cash impact — starting by adding back non-cash charges.

Cash Flow Impact: Changes in Net Working Capital (NWC)

Under accrual accounting, revenue is recognized when the product/service is delivered (i.e. “earned”), as opposed to when cash is received.

In effect, this leads to the creation of line items such as accounts receivable which is counted as revenue recognized on the income statement, but whose cash payment has not actually been received yet.

Moreover, the cash impact for changes in working capital are as follows:

Net Working Capital (NWC): Current Assets

• Increase in NWC Asset → Decrease in Cash
• Decrease in NWC Asset → Increase in Cash

Net Working Capital (NWC): Current Liabilities

• Increase in NWC Liability → Increase in Cash
• Decrease in NWC Liability → Decrease in Cash

If accounts receivable (A/R) were to increase, purchases made on credit have increased and the amount owed to the company sits on the balance sheet as A/R until the customer pays in cash.

Once the customer fulfills their end of the agreement (i.e. cash payment), A/R declines and the cash impact is positive.

Another current asset would be inventory, where an increase in inventory represents a cash reduction (i.e. a purchase of inventory).

On the other hand, if accounts payable (A/P) were to increase, the company owes more payments to suppliers/vendors but has not yet sent the cash (i.e. the cash is still in the company’s possession in the meantime).

Once the company pays the suppliers/vendors for the products or services already received, A/P declines and the cash impact is negative as the payment is an outflow.

With that said, an increase in NWC is an outflow of cash (i.e. ”use”), whereas a decrease in NWC is an inflow of cash (i.e. “source”).

Cash Flow from Operating Activities Limitations

Net income would be equivalent to CFO if net income were just comprised of cash revenue and cash expenses.

Cash flow from operations adjusts net income, which is an accounting measure susceptible to discretionary management decisions.

The major drawback is that capital expenditures (Capex) — typically the most significant cash outflow for companies — are not accounted for in CFO.

Therefore, cash flow from operations is more objective and less prone to accounting manipulation in comparison to net income, yet is still a flawed measure of free cash flow (FCF) and profitability.