What is cash flow from operating activities?

At the most basic level, cash flow from operating activities is a measure of the money that a company has available to pay for its primary operations. Companies with strong cash flow from operating activities are typically in a financially stronger position than those with weak, negative, or declining cash flow from operating activities.

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Cash flow from operating activities (CFO) is typically the first section that appears in a company’s cash flow statement, one of the three main company documents used in financial reporting. It measures the cash inflows and cash outflows from the company’s core business activities during a specific period. 

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It’s important for businesses to have a handle on the cash flow generated from their operating activities because it can provide clear insight into the overall financial health of a business. 

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In fact, many business leaders consider cash flow from operations the most important section of the cash flow statement. 

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Companies that have a negative cash flow from operations may run into liquidity issues and need to seek external funding in order to keep their business afloat. If you’re looking for capital from investors or lenders, it’s likely that they’ll also be interested in looking at your cash flow from operating activities to get a pulse on the viability of the business. 

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Cash flow from operating activities is different from net income (found on the income statement, another important financial statement), which factors in non-cash items. From that perspective, cash flow from operations is a better indicator of a company’s liquidity. It’s possible for a company to have a positive net income and negative cash flow from operations, and vice versa.

What are examples of cash flows from operating activities?

Cash flow from operating activities, also known as operating cash flow, is a measure of how much money comes into and goes out of a company through its normal operations, selling goods or providing services within a given period. Activities that might result in cash flow from operating activities include:

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• Sales transactions
• Cash payments received
• Tax payments
• Vendor payments 
• Supplier payments
• Rent or mortgage payments
• Insurance payments
• Utilities and other bills

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Cash flow from operating activities does not include the cash spent or generated via investing activities, such as buying or selling assets, or via financing activities, which include both debt and equity. Companies typically calculate those types of cash flows separately on their cash flow statement, and then consider them all together to determine whether or not the company is profitable. 

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While all companies have the goal of having positive cash flow from operating activities (and positive cash flow overall), many startups have negative cash flow from operating activities during the first few years of launch. That’s because they may be investing more into the business than they’re making in sales. 

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What is a good operational cash flow ratio?

While this is heavily dependent on your industry, a good operating cash flow (OCF) ratio typically falls between 1.0 and 1.5. This ratio measures a company's ability to cover its current liabilities with cash generated from its operations. A ratio of 1.0 or higher indicates that the company is generating enough cash from its operations to cover its current liabilities, suggesting good liquidity and financial health. While reviewing your cash flow, it’s important to compare it with industry standards for a more accurate assessment.

Why businesses need to know their cash flow from operating activities

Businesses need to know their cash flow from operating activities because it gives them a sense of how the business is doing and whether they have enough net cash to maintain operations. Even profitable companies sometimes have trouble paying their bills, an indication that they have not been properly managing their cash flow from operating activities. 

Having a solid understanding of your company’s cash flow from operations is key to not only more efficiently managing operations but also to better plan for future growth. While cash flow from operations is important on its own, you’ll also want to look at it in conjunction with your company’s cash flow from investing activities and its cash flow from financing activities. All three numbers are necessary to perform a cash flow analysis. 

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That said, cash flow from operating activities may be the most important of the three, since it’s a measure of the amount of cash the company can produce through its core operations, rather than its ability to raise capital or buy or sell its assets. For example, if a company sold a piece of property or equipment, that might result in a large influx of cash, but it would not impact cash flow from operations (because it would appear under the cash flow from investing activities). 

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Similarly, an increase in accounts receivable would show up on a balance sheet as an asset, but it would be deducted from net income when calculating operating cash flow, since there it has not yet translated to cash. On the other hand, an increase in accounts payable would be added, since the company still has the cash. 

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As a company grows over time, it can be even more important to manage cash flow from operating activities. It’s hard to expand operations if you don’t have the cash on hand to pay for additional employees or inventory. Plus, as costs increase and billing cycles potentially extend, making sure the company always has enough cash on hand can prevent potentially significant problems down the road. 

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Public companies must report their operating cash flow as part of the statement of cash flows filed as part of their quarterly and annual reports filed with the Securities and Exchange Commission (SEC). Investors and analysts look closely at these numbers when evaluating a company. 

Ways to calculate cash flow from operating activities

There are two different methods that companies use to calculate cash balance from operating activities, the direct method and the indirect method. Each method has its own pros and cons, but both methods should lead to the same final result.

Direct method

The direct method of calculating cash flow simply requires adding up all the money that customers have paid to the company over a given period and then subtracting all expenses. This may require adding up all invoices and receipts for both sales and expenses over a given period. 

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While that may require more time, organization, and legwork, going through the exercise can provide a more nuanced understanding of exactly where every dollar the company earns or spends is going. 

Indirect method

To use the indirect method you’d start with the net income figure on your company’s balance sheet and then adjust it for non-cash expenses and changes in working capital during that period, including depreciation, amortization, and taxes and interest paid. 

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As long as you have a reliable balance sheet with detailed line items, the indirect method is easier to use than the direct method, since it doesn’t require tracking down receipts and invoices.

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Companies that use accrual-based accounting may also prefer this method, because it can provide a more accurate picture of a company’s liquidity, than EBITDA. That’s because it’s possible to use creative accounting to manipulate EBITDA if companies have inflated appreciation or depreciation costs, but cash flow from operations does not allow for any wiggle room. 

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Cash flow from operating activities formula and calculation

While most businesses now use accounting software that will calculate cash flow from operations (and other important metrics) automatically, it can still be helpful to understand the formula and the inputs that go into the calculation. The formulas are fairly straightforward, so even if you don’t have an accounting or finance background, you should be able to understand and use them.

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For the direct method, the formula for calculating cash flow from operating activities is:

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Cash flow from operations = Total cash received – Cash paid for operating expenses

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For the indirect method, the formula for calculating cash flow from operating activities is: 

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Cash flow from operations = Net income + Non-cash expenses (i.e. depreciation and amortization) – change in working capital (assets - liabilities)

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In general, companies that have a positive operating cash flow have more liquidity than those with a negative operating cash flow. If your cash flow from operations is negative, there are several ways your business can improve it. These include:

• Reduce operating expenses
• Sell more products or services
• Increase your prices (if the gains outweigh any lost sales)
• Spend more efficiently 
• Tighten up the terms you offer to customers

While some companies only calculate or look at their cash flow from operating activities on a quarterly or annual basis, other companies track it on a monthly basis or even more frequently. If your company is struggling with liquidity issues, closely tracking cash flow from operations may help surface potential issues. 

What are adjustments on operating cash flow?

Adjustments to operating cash flows refer to modifications made to net income in order to reflect the actual cash flow generated by core business activities. These adjustments are necessary because net income, as reported on the income statement, includes non-cash items such as depreciation, amortization, and accrued expenses. The process involves adding back non-cash expenses to net income and adjusting for changes in working capital, such as accounts receivable, accounts payable, and inventory levels.

Examples of typical adjustments include adding back depreciation and amortization (since they are non-cash expenses), subtracting any increases in accounts receivable (as it reflects sales made but not yet collected in cash), and adding increases in accounts payable (as these are expenses incurred but not yet paid in cash). These adjustments ensure that the operating cash flow reflects the true cash position of the company based on its core operations.

Cash flow from operations and free cash flow

You can use cash flow from operations to determine a company’s free cash flow. 

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To calculate free cash flow, you’d begin with cash flow from operations and then deduct long-term capital expenditures, such as property or equipment. While cash flow from operations shows you how much money you have for every day operations, free cash flow shows you how much is “free” or leftover to spend on things like dividends or stock buybacks. 

Ramp can help companies control spend and manage cash flow

You probably already use accounting software, which automatically tracks your debits and credits and generates cash flow statements. But knowing your operating cash flow is just the first step in managing it. 

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Ramp is an expense management platform that connects with your accounting platform to give you instant visibility into your company’s spending, which is an important step in managing cash flow. By automating expense management and recognition, Ramp can free up your accounting team members to focus on more high-value projects like strategic planning. 

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Learn more about how Ramp can help you manage your cash flow.

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