Cash flow from operations is important to any business. Generally 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. Consequently 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. It is the cash equivalent of net income. Furthermore it represents cash in from selling goods less cash out from paying the expenses of selling goods.
Cash and the Financial Projections Template
In the financial projections template cash flow from operations is shown in the cash flow statement. The amount is under the heading cash flows from operating activities as indicated in the extract below.
Cash Flow From Operations Formula
Net income is arrived at by making various accounting adjustments for depreciation, accruals, and prepayments. Consequently to arrive at cash flow, the effect of these adjustments needs to be removed. This is summarized in the cash flow from operations formula as shown below.
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 and depreciation is added back as it is not a cash expense. Additionally 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 a business uses in it’s normal daily trading operations. In a simple business it is calculated as inventory plus accounts receivable less accounts payable. This represents the funding needed to buy inventory and provide credit to customers offset by the amount of credit obtained from suppliers.
As each element of working capital changes the cash flow to finance it changes. For example, as inventory increases cash flows out of the business to pay for the inventory. Additionally as accounts receivable increases less cash flows into the business as cash is not being received from customers. Finally, 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. Additionally it has opening inventory of 15,000 and closing inventory of 60,000,. For simplicity assume there are 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:
Operating cash flow = Net income + Depreciation - Changes in working capital Operating cash flow = 30,000 + 5,000 - 45,000 = -10,000 (cash flow out)
So, while the business is profitable (shown by the net income), the effect of the build up in inventory is to leave it short of cash (shown by the cash flow from operations).
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. Ideally the additional cash flow is funded internally, 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. Such external funding is dealt with in the cash flow from financing activities section of the cash flow statement.
The advantage of using operating cash flow 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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.