The operating activities section is the part of the statement of cash flows on financial reports where you find a summary of how much cash flowed into and out of the company during the day-to-day operations of the business.
Operating activities is the most important section of the statement of cash flows. If a company isn't generating enough cash from its operations, it isn't going to be in business long. Although new companies often don't generate a lot of cash in their early years, they can't survive that way for long before going bust.
The primary purpose of the operating activities section is to adjust the net income by adding or subtracting entries that were made in order to abide by the rules of accrual accounting that don't actually require the use of cash.
Depreciation
A company that buys a lot of new equipment or builds new facilities has high depreciation expenses that lower its net income. This fact is particularly true for many high-tech businesses that must always upgrade their equipment and facilities to keep up with their competitors.
The bottom line may not look good, but all those depreciation expenses don't represent the use of cash. In reality, no cash changes hands to pay depreciation expenses. These expenses are actually added back into the equation when you look at whether the company is generating enough cash from its operations because the company didn't actually lay out cash to pay for these expenses.
For example, if the company's net income is $200,000 for the year and its depreciation expenses are $50,000, the $50,000 is added back in to find the net cash from operations, which totals $250,000. Essentially, the firm is in better shape than it looked to be before the depreciation expenses because of this noncash transaction.
Inventory
Another adjustment on the statement of cash flows that usually adds cash to the mix is a decrease in inventory. If a company's inventory on hand is less in the current year than in the previous year, the company bought some of the inventory sold with cash in the previous year.
On the other hand, if the company's inventory increases from the previous year, then it spent more money on inventory in the current year, and it subtracts the difference from the net income to find its current cash holdings. For example, if inventory decreases by $10,000, the company adds that amount to net income on the statement of cash flows.
Accounts receivable
Accounts receivable is the summary of accounts of customers who buy their goods or services on direct credit from the company. Customers who buy their goods by using credit cards from banks or other financial institutions aren't included in accounts receivable.
Payments by outside credit sources are instead counted as cash because the company receives cash from the bank or financial institution. The bank or financial institution collects from those customers, so the company that sells the good or service doesn't have to worry about collecting the cash.
When accounts receivable increase during the year, the company sells more products or services on credit than it collects in actual cash from customers. In this case, an increase in accounts receivable means a decrease in cash available.
The opposite is true if accounts receivable are lower during the current year than the previous year. In this case, the company collects more cash than it adds credit to customers’ credit accounts. In this situation, a decrease in accounts receivable results in more cash received, which adds to the net income.
Accounts payable
Accounts payable is the summary of accounts of bills due that haven't yet been paid, which means the company must still lay out cash in a future accounting period to pay those bills.
When accounts payable increase, a company uses less cash to pay bills in the current year than it did in the previous one, so more cash is on hand. This has a positive effect on the cash situation. Expenses incurred are shown on the income statement, which means net income is lower.
But in reality, the company hasn't yet laid out the cash to pay those expenses, so an increase is added to net income to find out how much cash is actually on hand.
Conversely, if accounts payable decrease, the company pays out more cash for this liability. A decrease in accounts payable means the company has less cash on hand, and it subtracts this number from net income.
The cash flow from activities section, summed up
Here is a taste of what all these line items look like in the statement of cash flows.
| Line Item | Cash Received or Spent |
|---|---|
| Net income | $200,000 |
| Depreciation | 50,000 |
| Increase in accounts receivable | (20,000) |
| Decrease in inventories | 10,000 |
| Decrease in accounts payable | (10,000) |
| Net cash provided by (used in) operating activities | $230,000 |
The company has $30,000 more in cash from operations than it reported on the income statement, so the company actually generated more cash than you may have thought if you just looked at net income.
If you compare the statements for the toy companies Mattel and Hasbro in 2012 (you can download them at their respective websites), you can see that Mattel's net cash flow totaled $1,276 million after adjustments on $777 million net income, whereas Hasbro's net cash was $535 million on $336 million of net income.
For Hasbro, depreciation and amortization adjustments added $100 million to the company's net cash position. Mattel added $157 million to its net cash with depreciation and amortization. Mattel increased accounts payable, accrued liabilities, and income taxes by $312 million to hold on to cash. Hasbro decreased its cash with a $22 million decrease in accrued liabilities and accounts payable. It used $59 million in cash to pay for production costs.