Operating cash flow (OCF) is the lifeblood of a company and can be said to be the most important barometer for investors to judge the company’s well-being. Although many investors prefer net income, operating cash flow is often seen as a better indicator of a company’s financial health for two main reasons. First, under GAAP, cash flow is more difficult to manipulate than net income (although it can be done to a certain extent). Secondly, “cash is king”, companies that have not generated cash for a long time are dying.
But operating cash flow does not mean the same as EBITDA (earnings before interest, taxes, depreciation and amortization). Although EBITDA is sometimes referred to as “cash flow,” it is actually earnings before financing and capital investment decisions are affected. It does not include changes in working capital (inventory, accounts receivable, etc.). The actual operating cash flow is the figure derived from the cash flow statement.
Cash flow statement overview
The cash flow statement of non-financial companies consists of three main parts:
- Operating flow-net cash generated from operations (changes in net income and working capital).
- Investment flow-the net result of capital expenditures, investments, acquisitions, etc.
- Financing flow-the net result of raising cash to finance other flows or repay debt.
By obtaining net income and adjusting it to reflect changes in the working capital accounts (accounts receivable, accounts payable, inventory) and other current accounts on the balance sheet, the operating cash flow section shows how cash was generated during the period. It is this transition process from accrual accounting to cash accounting that makes operating cash flow statements so important.
Accrual System and Cash Flow
The concept of the cash cycle proves the main difference between accrual accounting and actual cash flow. The company’s cash cycle is the process of converting sales (accrual basis) into cash, as shown below:
- Cash is used to make inventory.
- Inventory is sold and converted to accounts receivable (because the customer has 30 days to pay).
- The customer receives cash when paying (this will also reduce the accounts receivable).
Cash from legal sales can be included in the balance sheet in a variety of ways. The two most common situations are customer delays in payment (causing the accumulation of accounts receivable) and rising inventory levels because products are not sold or are being returned.
For example, a company may legally record $1 million in sales, but because the sales allows customers to pay within 30 days, a $1 million in sales does not mean that the company earned $1 million in cash. If the payment date occurs after the end of the quarter, the accrued income will be greater than the operating cash flow because the $1 million is still in accounts receivable.
Harder to fabricate operating cash flow
Accrual accounting not only provides an interim report on the company’s profitability, but under GAAP, it allows management to have a range of options to record transactions. Although this flexibility is necessary, it also allows for manipulation of revenue. Since managers usually book business in a way that helps them earn bonuses, it is usually safe to assume that the income statement will exaggerate profits.
An example of revenue manipulation is called the “fill channel.” In order to increase sales, companies can provide retailers with incentives, such as extending deadlines or promising to reclaim inventory when it is not sold. Then the inventory will enter the distribution channel and the sale will be booked.
The accrued income will increase, but the cash may never actually be received because the inventory may be returned by the customer. Although this may increase sales for a quarter, it is a short-term exaggeration and will eventually “steal” sales for subsequent periods (because inventory is returned). (Note: Although loose return policies such as consignment sales are not allowed to be recorded as sales, as we all know, companies often do so during the market bubble.)
The operating cash flow statement will seize these gimmicks. When operating cash flow is less than net income, there will be problems in the cash cycle. In extreme cases, a company may have negative operating cash flow for several consecutive quarters, and according to GAAP, legally report earnings per share as positive. In this case, investors should determine the source of the cash loss (inventory, accounts receivable, etc.) and whether the situation is a short-term or long-term problem.
Although the operating cash flow statement is more difficult to manipulate, the company has ways to temporarily increase its cash flow. Some of the more common techniques include: delaying payments to suppliers (extending payables); selling securities; and offsetting expenses from previous quarters (such as restructuring reserves).
Some people believe that selling accounts receivable in exchange for cash—usually sold at a discount—is a way for companies to manipulate cash flow. In some cases, this behavior may be a cash flow manipulation; but it can also be a legitimate financing strategy. The challenge is to be able to determine the intentions of management.
Cash is king
A company can only survive on EPS for a limited time. Ultimately, it will require actual cash to pay the piper, suppliers, and most importantly bankers. There are many examples of once respected companies that went bankrupt because they couldn’t generate enough cash. The strange thing is that despite all this evidence, investors have been hypnotized by earnings per share and market momentum, while ignoring warning signs.
Investors can avoid many bad investments if they analyze the operating cash flow of a company. It’s not difficult, but you need to do it, because the person in charge of the conversation and the analyst are often concerned about earnings per share.