A company's ability to consistently generate positive cash flows from its daily business operations is highly valued by investors. Operating cash flow can uncover a company's true profitability. It’s one of the purest measures of cash sources and uses, and is the gateway between other reported financial statements.
The cash flow statement
Operating cash flow (or cash flow from operations - CFO) can be found in the cash flow statement, which reports the changes in cash versus its static counterparts: the income statement, balance sheet and shareholders’ equity statement. Specifically, the cash flow statement reports where cash is used and generated over specific time periods and ties the static statements together. By taking net income on the income statement and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories), 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.
The sources and uses of cash are broken down into categories of operating, investing, financing and, in some cases, supplemental activities.
1. Operating activities: records a company's operating cash movement, the net of which is where operating cash flow (OCF) is derived.
2. Investing activities: records changes in cash from the purchase or sale of property, plants, equipment or generally long-term investments.
3. Financing activities: reports cash level changes from the purchase of a company’s own stock orissue of bonds, and payments of interest and dividends to shareholders.
4. Supplemental information: basically everything that does not relate to the major categories.
Operating activities are normal and core activities within a business that generate cash inflows and outflows. They include:
- total sales of goods and services collected during a period;
- payments made to suppliers of goods and services used in production settled during a period;
- payments to employees or other expenses made during a period.
To see the importance of changes in operating cash flows, it’s important to understand how cash flow is calculated. Two methods are used to calculate cash flow from operating activities: indirect and direct, which both produce the same result.
Direct Method: This method draws data from the income statement using cash receipts and cash disbursements from operating activities. The net of the two values is the OCF.
Indirect Method: This method starts with net income and converts it to OCF by adjusting for items that were used to calculate net income but did not affect cash.
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Operating Cash Flows
OCF is a prized measurement tool as it helps investors gauge what’s going on behind the scenes. For many investors and analysts, OCF is considered the cash version of net income, since it cleans the income statement of non-cash items and non-cash expenditures (depreciation, amortization, non-cash working capital and changes in current assets and liabilities). OCF is a more important gauge of profitability than net income, as there is less opportunity to manipulate OCF to appear more or less profitable. With the passing of strict rules and regulations on how overly creative a company can be with its accounting practices, chronic earnings manipulation can easily be spotted, especially with the use of OCF. It is also a good proxy of a company’s net income; for example, a reported OCF higher than NI is considered positive, as income is actually understated due to the reduction of non-cash items.
Above are the reported cash flow activities for AT&T for its fiscal year 2012 (in millions). Using the indirect method, each non-cash item is added back to net income to produce cash from operations. In this case, cash from operations is over five times as much as reported net income, making it a valuable tool for investors in evaluating AT&T's financial strength.
The Bottom Line
Operating cash flow is just one component of a company’s cash flow story, but it is also one of the most valuable measures of strength, profitability and the long-term future outlook. It is derived either directly or indirectly and measures money flow in and out of a company over specific periods. Unlike net income, OCF excludes non-cash items like depreciation and amortization which can misrepresent a company's actual financial position. It is a good sign when a company has strong operating cash flows with more cash coming in than leaving. Companies with strong growth in OCF most likely have more stable net income, better abilities to pay and increase dividends, and more opportunities to expand and weather downturns in the general economy or their industry.
If you think “Cash is King,” strong cash flow from operations is what you should watch for when analyzing a company.