Complete Guide To Corporate Finance

Capital Investment Decisions - Operating Cash Flow And Alternative Definitions Of Operating Cash Flow

The cash flow statement summarizes a business's cash inflows and outflows over a period of time. It is important because it is very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason, some investors use the cash flow statement as a more conservative measure of a company's performance.

Operating cash flow (OCF) is found on the cash flow statement and is calculated through a series of adjustments to net income. OCF is arguably a better measure of a business's profits than earnings because a company can show positive net earnings on the income statement and still not be able to pay its debts. Cash flow is what pays the bills, and OCF can serve as a check on the quality of a company's earnings. If a firm reports record earnings but negative cash, it may be using aggressive accounting techniques.
Overview of the Statement of Cash Flows
The statement of cash flows for non-financial companies consists of three main parts:

1. Operating flows - The net cash generated from operations (net income and changes in working capital).

2. Investing flows - The net result of capital expenditures, investments, acquisitions, etc.

3. Financing flows - The net result of raising cash to fund the other flows or repaying debt.

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

Accrual Accounting vs. Cash Flows
The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows:

- Cash is used to make inventory.

-Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay).

-Cash is received when the customer pays (which also reduces receivables).

There are many ways that cash from legitimate sales can get trapped on the balance sheet. The two most common are for customers to delay payment (resulting in a buildup of receivables) and for inventory levels to rise because the product is not selling or is being 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 in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable.

Harder to Fudge Operating Cash Flows
Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits rather than understate them.

An example of income manipulation is called "stuffing the channel." To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually 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 ultimately "steals" sales from the following periods (as inventories are sent back). (Note: While liberal return policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.)

The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive earnings per share (EPS). In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem. (For more on cash flow manipulation, see Cash Flow On Steroids: Why Companies Cheat.)


Cash Exaggerations
While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves).

Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but it can also be a legitimate financing strategy. The challenge is being able to determine management's intent.

Cash Is King

A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs.

Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but it is important to do because the talking heads and analysts are all too often focused on EPS.

Alternative Methods of Calculating OCF

The bottom-up approach to operating cash flow takes the company's bottom line--that is, its net income--and adds back non-cash expenses such as depreciation and amortization.


OCF = N + D

The top-down approach starts with total sales and subtracts only cash expenses (primarily fixed costs, variable costs and taxes), leaving out non-cash expenses such as depreciation and amortization.

OCF = S - C - T

Because depreciation is tax deductible, it reduces a firm's tax liability. The tax shield method of computing operating cash flow takes this fact into account by multiplying the company's depreciation expense by its tax rate.

OCF = (S - C) x (1 - T) + D x T

Each of these three methods yields the same number for OCF.

(Taxes have a major impact on companies' bottom lines. Learn how in 6 Ways Small Businesses Can Save On Taxes.)



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