What is cash from operations?

Operating activities represent the cash inflows and outflows related to a company's core business operations, such as the sale of goods and services. The aim of this section is to calculate "Operating Cash Flow" (OCF).

Methods to Calculate Operating Activities

There are two methods to calculate operating cash flow:

1. Direct Method
2. Indirect Method (more commonly used)

We'll focus on the indirect method, which involves adjustments to net income, as calculated on the income statement, to reflect cash-based accounting.

The Indirect Method Breakdown

1. Starting with Net Income

• Net income is pulled from the income statement.
• Adjustments are made because the income statement is based on accrual accounting (which may record revenues and expenses before cash changes hands).

2. Adjusting for Non-Cash Items

• Items included in the income statement but not related to actual cash flow (e.g., depreciation and stock-based compensation) are added back.
• Items not yet paid or deferred (e.g., deferred taxes) are subtracted.

Example: Nike’s Cash Flow Statement

• Depreciation ($73 million): Non-cash expense, added back to net income.
• Deferred Income Taxes: Cash paid but not due, subtracted.
• Stock-based Compensation: Non-cash expense, added back.
• Foreign Currency Adjustments: These are adjustments for currency fluctuations, either added or subtracted depending on the impact.

3. Adjusting for Changes in Working Capital

• Working capital adjustments reflect changes in current assets and liabilities:
  • Increases in current assets (e.g., inventory): These represent cash spent, so they're subtracted.
  • Decreases in current liabilities (e.g., accounts payable): This means cash has been used to pay off these liabilities, so they are subtracted as well.
  • Conversely, increases in liabilities or decreases in assets add cash back.

Key Concept: Free Cash Flow

• Operating cash flow is an important measure for investors, as it's used to calculate free cash flow, which shows the true profitability of a business after capital expenditures.
• Formula:
  Free Cash Flow = Operating Cash Flow - Capital Expenditures

Summary

• Operating activities show how much cash a business generates or uses in its core operations.
• The indirect method is commonly used to calculate operating cash flow by adjusting net income for non-cash items and changes in working capital.
• Operating cash flow is critical for valuing a company, as it feeds into free cash flow calculations, which are essential for assessing profitability.