Cash from operating activities is a section in the cash flow statement that some people
find hard to understand.
However, once you grasp the logic and know where to look to find your data, it’s actually fairly easy!
I will help you understand what cash from operating activities means, and how to put it together.
The definition of cash flow from operating activities is: a section of a company's cash
flow statement that explains the sources and uses of cash from ongoing regular business
activities in a given period.
Ongoing regular business activities means selling products and services to customers
and receiving cash from these sales, purchasing goods and services from suppliers and paying
for them, paying salaries to employees, stuff like that.
Depending on the state of maturity and the level of success of the company or business
unit you are looking at, cash from operating activities can either be a net cash inflow
(a positive number) or a net cash outflow (a negative number).
Let’s look at the cash flow statement of a company you have probably heard of before: Apple.
And let’s look how cash from operating activities fits into the cash flow statement.
The format of the cash flow statement puts the cash balance at the beginning of the year
at the top, then lists cash from operating activities, cash from investing activities,
and cash from financing activities.
If you add and subtract all those numbers, you get to the cash balance at the end of
the year at the bottom.
For Apple in fiscal year 2020, they started the year with $50 billion, generated $81 billion
in CFOA, had a net cash outflow of $4 billion in CFIA, and a net cash outflow of $87 billion
in CFFA, to end the year with $40 billion.
Just to clarify: numbers between parentheses are negatives.
We will zoom into the positive $81 billion of cash from operating activities (a net cash
inflow) throughout this video.
Where does this come from, and how is it calculated?
The simple answer is: if you start the year with $50 billion (which can be verified from
the bank statements), and end the year with $40 billion (which can be verified from the
bank statements), then the total cash flow was a negative $10 billion.
In other words, a net cash outflow: more cash outflow than cash inflow.
There are only three types of cash flow (operating, investing and financing), of which investing
and financing are narrowly defined and easy to understand.
We know the numbers of cash from investing activities ($4 billion net cash outflow) as
well as cash from financing activities ($87 billion net cash outflow), so the simple mathematical
answer is that cash from operating activities must be $81 billion of net cash inflow.
If it wasn’t then things would not add up, would they?
A simple, but sadly too simplistic answer to pass the test of either submitting a 10-K
annual report to the SEC, or a finance and accounting exam.
One way to show detail within the cash from operating activities section, is to use the
direct method.
In the direct method, cash received from customers, cash paid to suppliers and employees, interest
received, interest paid, and income taxes paid, are separately listed line items that
are directly tracked.
Sadly, very few companies report cash from operating activities this way.
Most companies report cash from operating activities using the indirect method.
Here’s our $81 billion of CFOA for Apple (that we saw earlier) at the bottom of the
page, which is the operational net cash generated.
What does “indirect” refer to in the term “indirect method”?
Indirect means we start off from the income statement metric called net income (also known
as the “bottom line” of the income statement), which is a calculation of revenues earned
minus expenses incurred, and then make adjustments to arrive at the cash from operating activities number.
In our case study here, these adjustments add up to $23.3 billion.
If you want to be able to use the indirect method of reporting cash from operating activities,
then you have to understand the starting point first.
Net income for Apple in FY20 consisted of $275B of revenue earned, most but not all
of which was collected in the same year, and $218B of expenses incurred, most but not all
of which were paid in the same year.
$275B in revenues minus $218B in expenses equals $57B of net income.
This “most but not all” in both revenue and expenses is key: most revenue and most
expenses affect profit as well as cash flow in the same year, but some revenue and some
expenses affect cash flow in a different year than they affect profit!
Now that we understand the starting point of net income, what are the categories of
adjustments we need to make?
The first category, named here “adjustments to reconcile net income to cash generated
by operating activities” consists of adjustments from the profit view of a company to the cash
view of a company that come out of analyzing the income statement in more detail.
The second category, named here “changes in operating assets and liabilities” consists
of adjustments that come out of analyzing the balance sheet in more detail.
Let’s review the adjustments from top to bottom, and select a few of the big line items
to dive into more detail.
Depreciation and amortization.
Remember that as part of the net income calculation in the income statement, $218B of expenses
incurred were taken into account, most but not all of which were paid in the same year.
This number of $218B includes $11B of depreciation and amortization expenses, which are so-called
“non cash” expenses: expenses are recorded, but no cash is changing hands.
The cash outflow occurred when the assets were purchased.
Recording depreciation and amortization expense simply transfers a part of the value of the
assets from the balance sheet to the income statement over the years of use of the asset.
Recording depreciation and amortization expense is the right thing to do to state the income
statement correctly, but when you change from the profit view of a company to the cash flow
view of a company, you have to “neutralize” the effect.
If net income is $57B after deducting $11B of depreciation and amortization expense,
then you need to add back $11B in cash from operating activities to neutralize.
Minus $11B in the top row, plus $11B in the next row, sums to zero.
A similar story for share-based compensation expense.
This is an expense that needs to be deducted in order to calculate net income correctly,
but as share-based compensation expense is “paid” in shares and not in cash, the
effect needs to be “neutralized” for cash flow purposes.
Minus $6.8B in the top row, plus $6.8B in the third row, sums to zero.
The “changes in operating assets and liabilities” section gets us to review balance sheet movements
that have an effect on cash from operating activities.
Accounts receivable is a big line item here.
We need to distinguish clearly between the accounts receivable balance, and cash generated
or used by a change in the accounts receivable balance.
The definition of the accounts receivable balance is: the sum of invoices sent to customers
that they haven’t paid yet on the balance sheet date.
If you review Apple’s balance sheet, you will find on the assets side of the balance
sheet that the accounts receivable balance was $22.9B at year-end FY19,
and $16.1B at year-end FY20.
The balance went down from one year-end to the next.
What does that mean?
Well, simply that the sum of invoices sent to customers that they haven’t paid yet
is not as high as it used to be.
What happens if customers pay you?
Cash goes up!
As the accounts receivable balance went down, more cash came in, which is reflected by $6.9B
cash generated by the change in accounts receivable balance.
Further down, we see a change in accounts payable.
Once again, we need to distinguish clearly between the accounts payable balance, and
cash generated or used by a change in the accounts payable balance.
The definition of the accounts payable balance is: the sum of invoices received from suppliers
that you haven’t paid yet on the balance sheet date.
If you review Apple’s balance sheet, you find on the liabilities side of the balance
sheet that the accounts payable balance was $46.2B at year-end FY19,
and $42.3B at year-end FY20.
The balance went down.
What does that mean?
Simply that the sum of invoices received from suppliers that the company hasn’t paid yet
is not as high as it used to be.
What happens if you pay suppliers?
Cash goes down.
As the accounts payable balance went down, more cash went out, which is reflected by
the $4.1B cash used by the change in accounts payable balance.
Another example is deferred revenue, a liability account representing billings or payments
received in advance of revenue recognition.
If the balance goes up from $8.1B to $10.2B, then more cash came in, which is reflected
by the $2.1B generated by the change in deferred revenue balance.
The indirect method of reporting cash from operating activities reconciles net income
(revenues earned minus expenses incurred) to cash generated by operating activities,
by listing and explaining which adjustments to income statement and balance sheet accounts
need to be calculated.