Cash from Operations
Cash from Operations (CFO) is the cash generated (or burned) by a company's core business -- selling products, delivering services, paying employees.
CFO is the most important section of the cash flow statement. A company can survive negative CFI or CFF temporarily, but consistently negative CFO means the business model is broken.
The Indirect Method: Step by Step
The indirect method builds CFO in three layers:
- Start with Net Income -- pull it straight from the income statement
- Add back non-cash charges -- expenses that reduced net income but didn't actually cost any cash
- Adjust for working capital changes -- account for timing differences between when revenue/expenses are recognized and when cash moves
Non-Cash Add-Backs
These items reduced net income but didn't actually cost any cash:
| Item | Why It's Added Back |
|---|---|
| Depreciation & Amortization (D&A) | Cash was spent when the asset was purchased, not when depreciation is recorded |
| Stock-Based Compensation (SBC) | Employees get paid in shares, not cash -- real expense, no cash outflow |
| Deferred Taxes | Difference between taxes owed now vs. tax expense recorded -- non-cash portion added back |
| Amortization of Debt Issuance Costs | Financing fees expensed over time but paid upfront in cash |
D&A is by far the largest add-back for most companies. SBC can be significant for tech companies.
SBC: The 3-Statement Impact
Stock-based compensation is tested at Goldman Sachs. The key: it's a real operating expense, paid in equity instead of cash.
$10 SBC expense, 25% tax rate:
- IS: Operating expense +$10, Tax savings +$2.50, Net Income -$7.50
- CFS: NI -$7.50, SBC add-back +$10 (non-cash). Net cash +$2.50
- BS: Cash +$2.50, Retained Earnings -$7.50, APIC +$10 (equity issued to employees)
Check: Assets +$2.50 = Liabilities $0 + Equity (+$10 APIC - $7.50 RE) = +$2.50. ✓
Same tax shield logic as D&A. The twist: equity (APIC) increases because the company "paid" employees with stock. Total equity still goes up by $2.50 net ($10 APIC - $7.50 RE hit).
Working Capital Adjustments
This is where interviewers love to test you. The logic is simple once you internalize it:
Current assets go up = cash goes down. You spent cash (or didn't collect it yet).
Current liabilities go up = cash goes up. You owe money but haven't paid it yet -- that's cash you're holding onto.
| Working Capital Item | If It Increases... | If It Decreases... |
|---|---|---|
| Accounts Receivable (AR) | Cash flow decreases (you sold stuff but haven't collected yet) | Cash flow increases (you collected old receivables) |
| Inventory | Cash flow decreases (you bought more inventory) | Cash flow increases (you sold through inventory) |
| Prepaid Expenses | Cash flow decreases (you paid cash upfront) | Cash flow increases (the prepaid benefit is being used up) |
| Accounts Payable (AP) | Cash flow increases (you owe suppliers but haven't paid yet) | Cash flow decreases (you paid off suppliers) |
| Accrued Expenses | Cash flow increases (you recorded the expense but haven't paid cash) | Cash flow decreases (you paid out the accrual) |
AR up $10 = you booked revenue but didn't collect cash, so subtract it. AP up $10 = you recorded the expense but kept the cash, so add it back. Always ask: "Did the cash actually move?"
Worked Example
Company reports $100M net income, $20M D&A, AR up $15M, inventory down $5M, AP up $10M:
- +$20M D&A: Non-cash charge added back
- -$15M AR increase: Revenue booked but cash not collected
- +$5M inventory decrease: Sold through inventory, freeing up cash
- +$10M AP increase: Owe suppliers but haven't paid yet -- cash retained
"Walk me through CFO." Start with net income, add back non-cash charges (D&A, SBC), then adjust for working capital -- current asset increases subtract, current liability increases add. A common follow-up: "If AR increases by $10?" Cash flow decreases by $10 because revenue is already in net income but cash hasn't been collected.
Key Takeaways
- D&A is the largest non-cash add-back -- cash was spent when the asset was bought, not when depreciation is recorded
- Current asset increases subtract from cash flow; current liability increases add to cash flow
- The working capital logic always comes back to: "Did cash actually move?"
- Be able to walk through CFO start to finish in 30 seconds -- one of the most common interview questions