What it means
Profit is an accounting figure that includes items such as depreciation and sales not yet collected. Cash flow from operations strips these effects out and shows the actual cash the business produced.
It appears as the first section of the cash flow statement. There are two ways to present it.
The direct method lists cash received from customers and cash paid to suppliers and employees. The indirect method, far more common, starts with net income and adjusts for non-cash items and changes in working capital (the short-term assets and liabilities used in daily trading).
The main adjustments are easy to follow. Depreciation and amortisation are added back because they reduce profit without a cash payment.
Increases in receivables and inventory are subtracted because they tie up cash, while increases in payables are added because they delay cash payments. A healthy business generates positive operating cash flow over time, and it should usually exceed or roughly match net income.
If profit is high but operating cash flow is persistently weak, there may be problems with collection, stock or the quality of earnings. Analysts watch for that gap carefully.
It is also the starting point for other measures. Free cash flow is operating cash flow less capital spending, and ratios such as cash flow margin and the cash flow coverage ratio use it.
Lenders rely on it more than profit when deciding whether a company can repay a loan. Operating cash flow can be managed in the short run by delaying payments to suppliers or pushing customers to pay early.
Such moves improve the number without improving the business. Readers should look at the trend over several periods and at how working capital has moved.
In practice
Real-world examples
Example 1
A software firm reports net income of $1,000,000, but customers pay annual fees upfront. Deferred revenue rises by $600,000, so operating cash flow is higher than profit. The firm has more cash available than its income statement suggests. The cash flow statement shows this clearly, which is why the finance team presents both profit and cash together to the board.
Example 2
A furniture maker reports a profit of $500,000, yet its operating cash flow is only $150,000. Receivables have grown because a large retailer is paying late, and stock has built up in the warehouse. The finance director focuses on collections. The finance director also reviews the stock levels and agrees a plan with the sales team to turn old stock into cash.
Example 3
A consultancy shows net income of $250,000 and adds back $50,000 of depreciation on its computers. Working capital changes are small. Operating cash flow is about $300,000, and the partners use it to fund a new office fit-out. Because the figures are stable from year to year, the partners trust the cash forecast they build from it.
Think of it
Cash flow from operations answers: how much actual money did the core business produce?
Formula
Calculation
Cash flow from operations (indirect) = Net income + Depreciation and amortisation +/- Changes in working capital
Worked example: a company reports net income of $400,000 and depreciation of $120,000. Receivables rose by $90,000, inventory rose by $30,000, and payables rose by $40,000.
Step 1: Start with net income: $400,000.
Step 2: Add back depreciation: $400,000 + $120,000 = $520,000.
Step 3: Subtract the rise in receivables: $520,000 - $90,000 = $430,000.
Step 4: Add the rise in payables: $430,000 + $40,000 = $470,000.
Step 5: Subtract the rise in inventory: $470,000 - $30,000 = $440,000.
Cash flow from operations is $440,000, which is $40,000 higher than net income.Case study
Seen in the real world
Tidewater Textiles is an illustrative, fictional manufacturer that reported net income of $900,000 for the year. Its board was pleased until the finance manager showed that cash flow from operations was only $200,000. Receivables had grown by $500,000 and inventory by $350,000, while depreciation added back $150,000.
The finance manager walked the board through the calculation: $900,000 + $150,000 - $500,000 - $350,000 = $200,000. The company was profitable on paper but starved of cash. A new credit policy and stock review followed.
A year later, operating cash flow had risen to $1,100,000 on similar profit. The illustrative lesson is that cash flow from operations tests whether profit is turning into real money.
Watch out
Common mistakes
- Treating net income as the cash a business has generated, without adjusting for working capital and non-cash items.
- Adding back the increase in receivables, when an increase in receivables reduces cash.
- Judging a company on a single year, when working capital can swing sharply from one period to the next.
Questions
People also ask
Why can operating cash flow be higher than profit?
Non-cash costs such as depreciation, or customers paying in advance, can make cash flow exceed profit.
Is operating cash flow the same as EBITDA?
No, EBITDA is a profit measure before interest, tax, depreciation and amortisation, while operating cash flow includes working capital changes and tax and interest paid.
Which method should I use, direct or indirect?
Most companies use the indirect method, but the direct method gives a clearer picture of the actual cash received and paid. Auditors and lenders usually ask for a reconciliation between profit and operating cash flow either way.
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