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Nature of operating activities

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).

Operating activities are business activities associated with the primary purpose of a business. Examples of operating activities are listed in the table below:

Business

Operating Activities

ManufacturingManufacturing and selling goods
RetailBuying and re-selling goods
ServiceSelling 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).

Nature of operating activities

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