Operating cash flow is important because it provides the analyst insight into the health of the core business or operations of the company. Without a positive cash flow from operations a company cannot remain solvent in the long run. A negative operating cash flow would mean the company could not continue to pay its bills without borrowing money financing activity or raising additional capital investment activity. The Operating Cash Flow Calculation is operating income before depreciation minus taxes and adjusted for changes in working capital.
No matter how you choose to measure cash flow, it is still important. Cash flow and OCF is what helps companies expand, launch new products, pay dividends, and even reduce debt.
They may have to borrow money, or in the worst case — go out of business. Having a negative cash flow is acceptable at times, but should not become a habit. If the negative cash flow can be attributed to temporary expansion costs, then that is fine. This article was published more than 8 years ago. Some information may no longer be current. 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. 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.
Furthermore, in November and December , the Financial Accounting Standards Board issued exposure drafts proposing that every corporate financial statement include information on cash flows during the particular period. While we applaud attempts to glean better information on corporate past and future performance, we fear that operating cash flow may come to be regarded as the barometer for gauging company performance.
The growing legion of supporters of operating cash flow—which has great intuitive appeal—would be hard pressed to produce objective evidence of its superiority. The most compelling proof of the usefulness of OCF data that we have discovered is a study of W. Grant that appeared in the Financial Analysts Journal.
This one finding, while provocative, does not substitute for a broad-based study of a possible relation between the level of operating cash flow and future financial condition. A study we have made of nearly companies raises serious doubt about the reliability of operating cash flow as a financial indicator. We calculated three variables, operating cash flow OCF , operating cash flow divided by current liabilities CL , and operating cash flow divided by total liabilities TL.
OCF has a serious drawback as a measure of potential financial distress because it disregards size-of-business considerations as well as any unused borrowing capacity. What did we find? We found that none of the variables could discriminate between the bankrupt and nonbankrupt companies with reasonably good accuracy.
Exhibit I shows the percentages of accurate classifications. So, operating cash flow data are not the Holy Grail that some have made them out to be. One would think that the operating cash flow measure would have utility in predicting bankruptcy, since an impending collapse usually sends clear signals.
Perhaps more important, the cash flow numbers failed to improve predictive accuracy when we analyzed them together with the accrual-based ratios. That is, the OCF data did not have even marginal value. For our research we defined OCF as working capital provided by operations plus or minus changes in the noncash working capital accounts, except for short-term debt seasonal bank loans, nontrade notes payable, and the current portion of long-term debt.
This is also the way the FASB defines it. The insert supplies further information on the nature of cash flows. Because it includes changes in working capital accounts, however, OCF differs sharply from the more traditional definition of cash flow used by many analysts: net income plus depreciation and other operating items that do not affect working capital.
The failed companies represented a range of sizes and industry classifications and included, besides W. Financial data for the healthy companies spanned the same period as for the failed companies.
The poor predictive ability shown in Exhibit I is due to the large number of inaccurate classifications of nonbankrupt companies as failures because they do not generate much operating cash flow. This finding reinforces our concern that too much reliance on OCF may cause investors and creditors to view otherwise healthy companies as financially distressed.
Although many companies generate little OCF in some periods, most of them do not go belly up. Compare the well-known situations of Pan American and Braniff. Yet Pan Am has survived, while Braniff filed for bankruptcy in May
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