Nature of operating activities
Business activities can be divided into three (3) groups:
- Operating activities
- Investing activities
- Financing activities
Operating activities are day-to-day business activities of a company
which determine the company's net income (loss).
Examples of operating activities are listed
in the table below:
Business
|
Operating Activities
|
Manufacturing | Manufacturing and selling goods |
Retail | Buying and re-selling goods |
Service | Selling and providing services |
Operating activities involve transactions that create revenues and
expenses and thus are used to determine net income (loss). In other words,
operating activities are principal revenue producing activities.
The results of operating activities are reported in the
operating income section of the income statement and in the operating
cash flows section of the statement of cash flows. Balance sheet also
reflects some of the results of operations (e.g., working capital, long-term
assets, and liabilities).
For example, the statement of cash flows classifies cash receipts and
payments as operating, investing, and financing activities. Typical cash
receipts and payments within the operating activities category are provided
below:
Operating cash receipts (inflows):
- Revenue from the sale of goods and services
- Interest income (i.e., return on loans)
- Dividends income (i.e., return on equity securities)
- Royalties, fees, commissions, and other revenue
Operating cash payments (outflows):
- Payments to employees for services
- Payments to suppliers for inventory
- Payments to lenders for interest
- Payments to government for taxes
- Payments to others for operating expenses (e.g., insurance premiums)
Important to note, some cash flows related to financing and
investing activities (e.g., interest, dividend) are reported as
operating activities on the statement of cash flows when these items
involve income determination (i.e., are reported in the income statement).
For example, even though loan proceeds and repayment involve financing
activities, interest expense is reported as an operating activity because
interest expense is reported in the income statement.
Operating cash flows and a company’s net income (loss) are seldom equal
due to the depreciation and amortization expense, changes in current assets and
current liability accounts, etc.
It is important to evaluate operating cash flows when analyzing an
entity’s going concern because a company often depends on its
operating cash flows to meet its cash flow needs.
Negative operating cash flows, combined with cash inflows from
investing (e.g., selling assets) and financing activities (e.g., borrowing), may
indicate a serious financial problem.
On the other hand, positive operating
cash flows combined with negative investing cash flows indicate goods
financial performance and growth. An excess in operating cash flows can be used
for financial purposes (e.g., pay dividends, repurchase stock, repay debt) and
growth (e.g., buy assets).
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