How to calculate cash flow from operations
Introduction
Cash flow from operations (CFO) is a critical financial metric for businesses, as it measures the cash generated from a company’s core business operations. Proper calculation of CFO is essential for assessing a company’s financial health, investment worthiness, and operational performance. In this article, we’ll walk you through the steps to calculate cash flow from operations using both the direct and indirect methods.
Direct Method
The direct method calculates cash flow from operations by summing all cash receipts and payments related to a company’s operating activities. Follow these steps to calculate CFO using the direct method:
1. Identify all cash inflows: Start by calculating all cash collected from customers or clients during the period under consideration. This includes sales revenue, service fees, and other income related to the company’s core business activities.
2. Identify all cash outflows: Next, determine all cash payments made in connection with the company’s operating activities. This includes payments to suppliers for materials or services, wages and salaries paid to employees, rent expenses, utilities, and any other direct operating expenses.
3. Calculate net cash flow from operations: Subtract total cash outflows from total cash inflows to obtain your net cash flow from operations (CFO).
Indirect Method
The indirect method is the preferred method for calculating CFO for most companies due to its practicality and ease of use. The calculation begins with the net income reported on the income statement and accounts for adjustments in non-cash items such as depreciation, working capital changes, and deferred taxes. Follow these steps to calculate CFO using the indirect method:
1. Start with net income: Begin by taking your company’s net income or profit (from the income statement) during the period under consideration.
2. Adjust for non-cash items: Add back any depreciation or amortization expenses as these are non-cash expenses that reduce net income but do not represent true cash outflows.
3. Adjust for working capital changes: Analyze the changes in working capital accounts such as accounts receivable, inventory, and accounts payable. If an account has increased, it means that cash has been consumed by that item; therefore, it should be subtracted from the net income. Conversely, if an account has decreased, it indicates that cash has been released; in this case, add the decrease to the net income.
4. Consider other adjustments: Adjust for other non-cash items such as deferred taxes and any gains or losses due to non-operating activities.
5. Calculate net cash flow from operations: Add all of your adjustment values to the net income to obtain your cash flow from operations (CFO).
Conclusion
Understanding how to calculate cash flow from operations is vital for businesses to assess their financial performance and ability to generate positive cash flows from ongoing business activities. Both the direct and indirect methods provide valuable insights into a company’s overall financial health, but the indirect method is often more widely used for its practicality and ease of use. By following these steps for calculating CFO, you can gain a deeper understanding of your company’s operational efficiency and liquidity position.