Cash Flow from Operations

Nearly all companies report CFO using the indirect method, which starts at the bottom of the income statement and works up to cash: (1) Start with NET INCOME. (2) Add back NON-CASH EXPENSES — primarily depreciation and amortization, stock-based compensation, deferred taxes, and impairments — because these reduced net income but no cash left the company. (3) Adjust for CHANGES IN WORKING CAPITAL — an increase in accounts receivable or inventory USES cash (subtract), while an increase in accounts payable or deferred revenue is a SOURCE of cash (add). The result is the cash thrown off by operations before any investing or financing decisions.

CFO is the line that's hardest to fake. A company can report rising net income while hemorrhaging cash if it's booking revenue it can't collect (ballooning receivables) or stuffing the channel (rising inventory). Comparing net income to CFO is a core quality-of-earnings check: if net income consistently exceeds CFO, earnings quality is suspect. CFO is also the starting point for unlevered and levered free cash flow, and it's used in valuation multiples like Price/Operating Cash Flow. Lenders watch CFO because it shows whether the business can service debt from operations rather than from selling assets or raising capital.

The single trickiest part of CFO is the sign convention on working capital. Think in terms of cash: when receivables go UP, you've made sales but not collected the cash — so cash is lower than profit suggests, and you subtract the increase. When payables go UP, you've received goods or services but haven't paid for them yet — you're holding onto cash, so you add the increase. A fast-growing company often shows weak CFO because growth consumes working capital (more inventory, more receivables); a shrinking company can show artificially strong CFO as it liquidates working capital. Always ask whether CFO strength is durable or a one-time working-capital release.