Operating Cash Flow: Better Than Net Income?

Operating cash flow (OCF) is the lifeblood of a company and arguably the most important metric investors have for judging a company’s well-being. Although many investors gravitate toward net income, operating cash flow is often viewed as a better measure of a company’s financial health for two main reasons. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to some extent). Second, “cash is king,” and a company that does not generate cash over the long term is on its deathbed.

But operating cash flow does not mean the same thing as EBITDA (earnings before interest, taxes, depreciation, and amortization). While EBITDA is sometimes called “cash flow,” it is actually earnings before the effects of financing and capital investment decisions. It does not capture changes in working capital (inventory, accounts receivable, etc.). True operating cash flow is the figure derived on the statement of cash flows.

Overview of the statement of cash flows

The statement of cash flows for non-financial companies consists of three main parts:

• Operating flows – net cash generated from operations (net income and changes in working capital).
• Investment flows – the net result of capital expenditures, investments, acquisitions, etc.
• Financing flows – the net result of raising cash to finance other flows or pay off debt.

By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, and inventory) and other checking accounts, the operating cash flow section shows how cash was generated during the period. It is this process of translation from accrual accounting to cash accounting that makes the operating cash flow statement so important.

Accrual accounting versus cash flows

The main differences between accrual accounting and real cash flow are explained through the concept of the cash cycle. A company’s cash cycle is the process that converts sales (accrual accounting) into cash as follows:

• Cash is used to make an inventory.
• Inventory is sold and transferred to accounts receivable (because customers are given 30 days to pay).
• Cash is received when the customer pays (which also reduces receivables).

There are several ways in which cash generated from legitimate sales can be held on the balance sheet. The two most common reasons are customers delaying payment (leading to a backlog of receivables) and high inventory levels because the product does not sell or is returned.

For example, a company may legitimately record a $1 million sale, but because that sale allowed the customer to pay within 30 days, the $1 million sales does not mean the company generated $1 million in cash. If the payment date occurs after the quarter-end close, accumulated earnings will be greater than operating cash flow because the $1 million is still in accounts receivable.

Operating cash flows are difficult to manipulate

Not only can accrual accounting provide a more or less provisional report on a company’s profitability, but under GAAP it allows management a range of options for recording transactions. While this flexibility is necessary, it also allows profits to be manipulated. Since managers generally book business in a way that helps them earn their bonuses, it’s usually safe to assume that the income statement will overstate earnings.

One example of income manipulation is called “channel stuffing.” To increase its sales, a company can offer retailers incentives such as extended lead times or a promise to take back inventory if it doesn’t sell. The inventory will then be transferred to the distribution channel and sales will be booked.

Accumulated profits will increase, but cash may never be received because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and eventually “steals” sales from subsequent periods (as inventories are repatriated). (Note: While liberal returns policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so frequently during a market bubble.)

The operating cash flow statement will capture these tricks. When operating cash flow is less than net income, something is wrong with the cash cycle. In extreme cases, a company can have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this case, investors must determine the source of the cash bleeding (inventory, receivables, etc.) and whether this situation represents a short-term problem or a long-term problem.

Critical exaggeration

While the operating cash flow statement is more difficult to manipulate, there are ways for businesses to temporarily boost cash flows. Some of the most common techniques include: delaying payment to suppliers (extending amounts payable); Selling securities. And cancel the fees that were imposed in previous quarters (such as restructuring reserves).

Selling receivables for cash – usually at a discount – is seen by some as a way for companies to manipulate cash flow. In some cases, this action may amount to cash flow manipulation; But it can also be a legitimate financing strategy. The challenge lies in being able to determine management’s intent.

Cash is king

A company can only survive on earnings per share alone for a limited time. Eventually, you’ll need actual cash to pay pipeline companies, suppliers, and, most importantly, bankers. There are many examples of once-respected companies that went bankrupt because they couldn’t generate enough cash. Oddly enough, despite all this evidence, investors are constantly hypnotized by EPS and market momentum, and ignore the warning signs.

Bottom line

Investors can avoid a lot of bad investments if they analyze a company’s operating cash flow. It’s not hard to do, but you’ll need to do it because speakers and analysts often focus on earnings per share.