Cash flow from operations is important to any business, a business will not fail through lack of profit, but it will fail for lack of cash. In order to survive without external funding, a business needs to be able to generate sufficient cash from its trading activities.
Looking at the net income of a business from the income statement tells you about profit not cash, to find operating cash flow you need to look at the cash flow statement and in particular the cash flow from operations.
Cash flow from operations tells you how much cash a business generated from its operating (trading) activities and is the cash equivalent of net income. It represents cash in from selling goods less cash out from paying the expenses of selling goods.
Cash Flow From Operations Formula
Net income is arrived at by making various accounting adjustments for depreciation, accruals, and prepayments, to arrive at cash flow, the effect of these adjustments needs to be removed, giving the cash flow from operations formula as:
This formula in effect converts the net income from an accruals basis to a cash basis of accounting.
Net income comes from the income statement, depreciation is added back as it is not a cash expense, and the purpose of the working capital adjustment is to adjust the net income from an accruals basis to a cash basis of accounting.
The term working capital refers to the net liquid assets of a business used in it’s normal day to day trading operations. In a simple business it would be calculated as inventory plus accounts receivable less accounts payable, representing 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 to finance working capital changes. For example, as inventory increases cash flows out of the business to pay for the inventory, as accounts receivable increases less cash flows into the business as cash is not being received from customers, and as accounts payable increases less cash flows out of the business as suppliers are not being paid.
Cash Flow From Operations Example
As an example of calculating cash flow from operations, suppose a business has a net income of 30,000, including a depreciation expense of 5,000, and has opening inventory of 15,000 and closing inventory of 60,000, and for simplicity, no changes in accounts receivable or accounts payable.
The inventory has built up during the accounting period resulting in a change in working capital of 60,000 – 15,000 = 45,000. The cash flow from operations formula shows that:
Cash flow from operations = 30,000 + 5,000 – 45,000 = -10,000 (a cash flow out of the business)
So, while the business is profitable (shown by the net income) the effect of the build up in inventory is to leave the business short of cash (shown by the cash flow from operations).
In the financial projections template cash flow from operations is shown in the cash flow statement under the heading cash generated by operating activities.
|Add back depreciation||5,000|
|Less to fund working capital||-45,000|
|Cash flow from operations||-10,000|
Clearly the business does not have sufficient net income to sustain the increase in inventory. The net effect of this is that cash is needed from elsewhere, for example by taking credit from suppliers or improving collections from customers. Alternatively external forms of working capital finance such as cash flow factoring and overdrafts could be used, which is dealt with later, further down the cash flow statement.
The advantage of using cash flow from operations as well as net income, is that it highlights the adequacy of the trading activities to fund the business, draws attention to the changes in working capital of the business, and identifies the need for additional external funding.