What it means
A business exists to turn its activities into cash, and cash flow from operations is the measure of whether it does. It excludes cash spent on buying long-term assets (investing) and cash raised from or returned to lenders and shareholders (financing), so that what remains is the cash the operations themselves produced.
The indirect method starts with profit (operating profit or net income, depending on the framework) and adjusts it in three groups. Non-cash items are added back or deducted: depreciation and amortisation (charged against profit but no cash left), impairment, provisions charged or released, share-based payment expense, unrealised foreign exchange gains and losses, and profits or losses on asset disposals (which belong in investing).
Working capital movements are then applied: an increase in receivables is deducted (sales made but cash not yet received), an increase in inventory is deducted (cash spent on stock not yet sold), an increase in payables is added (costs incurred but cash not yet paid), and decreases the reverse. Finally, cash items that are not in operating profit are dealt with: tax paid is deducted, and interest paid and received are deducted or added if the company classifies them as operating (required under US GAAP, a choice under IFRS).
The direct method lists the actual flows: cash received from customers, cash paid to suppliers, cash paid to employees, other operating payments, tax paid. It is more intuitive and is encouraged by the standards, but few companies use it because the indirect reconciliation is easier to prepare and, for analysts, more informative.
What the figure reveals: a business whose operating cash flow consistently matches or exceeds its profit is converting sales into money and its profit is real. One whose operating cash flow lags profit is either growing fast (working capital absorbing cash legitimately), or collecting slowly, or building inventory, or recognising profit that has not been earned in cash terms.
The reconciliation shows which. Persistent negative operating cash flow is sustainable only while external funding lasts, which is the position of most start-ups and of businesses in serious trouble.
Operating cash flow is the numerator of most cash-based ratios: cash conversion (to profit or EBITDA), cash flow margin (to revenue), cash flow to debt, and the various coverage ratios. Less capital expenditure it becomes free cash flow, the figure valuations and distribution decisions rest on.
Its trend over several years, compared with the trends in profit and revenue, is the most reliable single indicator of whether a business is genuinely getting better or worse. Presentation choices affect comparability.
Interest paid in operating (US GAAP, and many IFRS reporters) versus financing (some IFRS reporters) can move several million between sections; dividends received, lease payments (now split between interest in operating or financing and principal in financing) and restructuring costs are other areas where policies differ. Analysts standardise before comparing.
In practice
Real-world examples.
Example
A subscription business reports operating cash flow 30% above its operating profit because customers pay a year in advance and deferred revenue grows with sales.
Example
A construction contractor reports operating cash flow of $2 million on profit of $15 million because three large projects have absorbed working capital ahead of milestone payments.
Example
A start-up reports negative operating cash flow of $8 million, funded by a share issue in financing, and reports the figure to investors as its annual burn.
Think of it
“Cash flow from operations answers: how much actual money did the core business produce?
Formula
Calculation
Indirect method: Cash Flow from Operations = Operating profit + Depreciation and amortisation + Other non-cash charges minus Non-cash gains minus Increase in receivables minus Increase in inventory + Increase in payables minus Tax paid (minus Interest paid, where classified as operating)
Direct method: Cash Flow from Operations = Cash from customers minus Cash to suppliers minus Cash to employees minus Other operating cash payments minus Tax paid (minus Interest paid)
Worked example. A distribution company reports operating profit of $9,600,000. Its notes show: depreciation $2,100,000; amortisation of software $400,000; impairment of a warehouse $700,000; profit on sale of vehicles $150,000 (included in operating profit); share-based payment expense $250,000; increase in a warranty provision $180,000; receivables up from $14,200,000 to $16,900,000; inventory up from $11,000,000 to $10,400,000; trade payables up from $9,300,000 to $10,100,000; tax paid $2,050,000; interest paid $1,100,000 (classified as operating).
Reconciliation:
- Operating profit: $9,600,000
- Add depreciation and amortisation: $2,500,000
- Add impairment: $700,000
- Deduct profit on disposal (belongs in investing): minus $150,000
- Add share-based payment: $250,000
- Add provision increase: $180,000
- Cash generated before working capital = $13,080,000
- Increase in receivables: minus $2,700,000
- Decrease in inventory: plus $600,000
- Increase in payables: plus $800,000
- Cash generated from operations = $11,780,000
- Tax paid: minus $2,050,000
- Interest paid: minus $1,100,000
- Cash flow from operations = $8,630,000
Cash conversion: $8,630,000 / $9,600,000 = 90% of operating profit. Before working capital, EBITDA-based conversion is high; the $2,700,000 receivables increase is the item to examine. Revenue grew 9% while receivables grew 19%: DSO has lengthened from about 48 to 52 days. Not alarming in one year, but flagged for the credit control review.
Direct-method view of the same figures (derived): revenue $118,000,000 minus receivables increase = cash from customers $115,300,000; purchases and operating costs after payables and inventory movements = cash to suppliers and employees about $103,520,000; tax $2,050,000; interest $1,100,000: total $8,630,000. The two methods agree, as they must.
Reading against the other sections: capital expenditure was $4,200,000, so free cash flow was $4,430,000; dividends of $3,000,000 and loan repayments of $1,500,000 were covered with $70,000 to spare. The impairment of $700,000 reduced profit but not cash; the disposal profit of $150,000 increased profit while the $900,000 of proceeds sit in investing.Case study
Seen in the real world.
A listed consumer products company had reported five years of operating profit growth, from $40 million to $72 million, with a share price to match. A hedge fund analyst built the operating cash flow reconciliation for each year from the notes. Cash flow from operations had gone from $42 million to $31 million.
The gap was in three lines: receivables had grown from 45 to 78 days of sales as the company extended credit to distributors in new markets and shipped stock at quarter ends to meet targets; inventory had grown from 60 to 95 days as slow-moving lines accumulated; and a growing "other non-cash items" line turned out to be the release of provisions made in the acquisition accounting of two purchases, which had boosted profit by $9 million over three years without a dollar of cash. The fund took a short position.
Within a year the company announced that it would take back $20 million of stock from distributors who could not sell it, wrote down $14 million of inventory, and restated the provision releases; profit fell to $35 million and the shares halved. The analyst's note observed that the operating cash flow reconciliation had contained the entire story in public documents, and that the only skill required had been to read it.
Watch out
Common mistakes.
- Judging a company on profit without checking cash flow from operations. A widening gap between the two is the most reliable early sign of trouble.
- Forgetting to remove disposal gains and losses from operating cash flow. The proceeds belong in investing, and leaving the gain in overstates operations.
- Comparing companies without adjusting for where interest, dividends received and lease payments are classified.
Questions
People also ask.
Why is cash flow from operations different from EBITDA?
EBITDA is profit before interest, tax, depreciation and amortisation, an accounting measure. Operating cash flow additionally reflects working capital movements, other non-cash items, and tax (and often interest) actually paid. EBITDA is a rough proxy for cash generation; operating cash flow is the measured figure.
Should I use the direct or indirect method?
Companies mostly present the indirect method. Analysts prefer it because the reconciliation from profit shows why cash and profit differ. The direct method is more intuitive for understanding the flows themselves.
What is a good level of cash flow from operations?
Consistently at or above operating profit for a mature business; lower for a growing one, with the working capital absorption proportionate to growth. Negative operating cash flow requires external funding and cannot last.
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