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What is Cash Flow?Cash flow is the blood of a business. It is the measure of what cash is coming in and what is leaving. Cash flow is a more accurate measure of whether a
company has enough capital to sustain itself. For example, a company can be extremely profitable and still go out of
business due to poor cash flow. [button link=”https://strategiccfo.com/25-ways-to-improve-cash-flow/?utm_source=wiki&utm_medium=button%20cta” bg_color=”#eb6500″]Download The 25 Ways to Improve Cash Flow[/button] Cash Flow StatementsCash flow statements are broken down into three areas. The areas are operating activities, investing activities, and financing activities. The idea behind separating these sources of cash is to get a better idea of where the cash is coming from. A detailed cash flow statement shows what amount came from loans, products/services, and investments. This can be very useful to investors and lenders. What is Net Income?Net income is calculated by subtracting total expenses from revenue. This is the
‘profit’ that most people refer to. Within the total expenses to be subtracted from revenue, overhead and cost of goods/services are both included. This means that
net income is the measure of whether a company actually made money during a period. Due to accrual accounting,
net profit does not automatically mean a business has cash. However, net income is efficient at tracking business done within a period. This makes net income a better estimate of
profitability than cash flow.  [box]Strategic CFO Lab Member Extra Click here to access your Execution Plan. Not a Lab Member? The amount of cash a company generates from its operating activities What is Cash Flow from Operations?Cash flow from operations is the section of a company’s cash flow statement that represents the amount of cash a company generates (or consumes) from carrying out its operating activities over a period of time. Operating activities include generating revenue, paying expenses, and funding working capital. It is calculated by taking a company’s (1) net income, (2) adjusting for non-cash items, and (3) accounting for changes in working capital. Cash Flow from Operations FormulaWhile the exact formula will be different for every company (depending on the items they have on their income statement and balance sheet), there is a generic cash flow from operations formula that can be used: Cash Flow from Operations = Net Income + Non-Cash Items + Changes in Working Capital Learn more with detailed examples in CFI’s Financial Analysis Course. Cash Flow from Operations ExampleBelow is an example of Amazon’s operating cash flow from 2015 to 2017. As you can see in the screenshot below, the statement starts with net income, then adds back any non-cash items, and accounts for changes in working capital. Follow these three steps:
Cash Flow from Operations vs Net IncomeOperating cash flow is calculated by starting with net income, which comes from the bottom of the income statement. Since the income statement uses accrual-based accounting, it includes expenses that may not have actually been paid for yet. Thus, net income has to be adjusted by adding back all non-cash expenses like depreciation, stock-based compensation, and others. Once net income is adjusted for all non-cash expenses it must also be adjusted for changes in working capital balances. Since accountants recognize revenue based on when a product or service is delivered (and not when it’s actually paid), some of the revenue may be unpaid and thus will create an accounts receivable balance. The same is true for expenses that have been accrued on the income statement, but not actually paid. Sample CalculationLet’s look at a simple example together from CFI’s Financial Modeling Course. Step 1: Start calculating operating cash flow by taking net income from the income statement. Step 2: Add back all non-cash items. In this case, depreciation and amortization is the only item. Step 3: Adjust for changes in working capital. In this case, there is only one line because the model has a separate section below that calculates the changes in accounts receivable, inventory, and accounts payable. Cash Flow from Operations vs EBITDAEarnings Before Interest Taxes Depreciation and Amortization (EBITDA) is one of the most heavily quoted metrics in finance. Financial Analysts regularly use it when comparing companies using the ubiquitous EV/EBITDA ratio. Since EBITDA doesn’t include depreciation expense, it’s sometimes considered a proxy for cash flow. Since EBITDA excludes interest and taxes, it can be very different from operating cash flow. Additionally, the impact of changes in working capital and other non-cash expenses can make it even more different. Learn more in CFI’s Business Modeling Courses. Capital ExpendituresWhile operating cash flow tells us how much cash a business generates from its operations, it does not take into account any capital investments that are required to sustain or grow the business. To get a complete picture of a company’s financial position, it is important to take into account capital expenditures (CapEx), which can be found under Cash Flow from Investing Activities. Deducting capital expenditures from cash flow from operations gives us Free Cash Flow, which is often used to value a business in a discounted cash flow (DCF) model. Learn to build a DCF model in CFI’s Business Valuation Modeling Course! Additional ResourcesThank you for reading this guide to understanding what cash flow from operations is, how it’s calculated, and why it matters. To learn more and continue building your career as a credit analyst, these additional CFI resources will be helpful:
What affects net income but not cash flows from operating activities?Non-cash expenses, such as depreciation, amortization, and share-based compensation, must be included in net income, but those costs do not reduce the amount of cash a company generates in a given period. As a result, these expenses are added back into the cash flow statement.
Why does net income differ from cash flow from operating activities?Net Income is the result of revenues minus the expenses, taxes, and costs of goods sold (COGS). Operating cash flow is the cash generated from operations, or revenues, less operating expenses. Many investors and analysts prefer using operating cash flow as an indicator of a company's health.
Why the net income on the income statement does not equal the change in the cash balance?Net income is an accounting metric and does not represent the economic profit or cash flow of a business. Since net profit includes a variety of non-cash expenses such as depreciation, amortization, stock-based compensation, etc., it is not equal to the amount of cash flow a company produced during the period.
What does Cash flow from operations not include?Cash flow from operating activities does not include long-term capital expenditures or investment revenue and expense. CFO focuses only on the core business, and is also known as operating cash flow (OCF) or net cash from operating activities.
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What does net income measure that the cash flow from operating activities does not?
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