Not many of us use operating cash flow to gauge the strength of a business. The use of net income/ profit more popular as an indicator among investors. But let me remind you that operating cash flow is better tool for investors. Operating cash flow is that parameter of business performance that companies manager cannot manipulate so for you it gives a much real picture than net profit (which is often manipulated). Moreover a company which is generating negative cash flow over a long time can be sure to die its own death.
Where can you find the operating cash flow? Some may argue that income statement will provide you this figure, but mind my words, we are talking about ‘operating cash flow’ and not operating profit. Operating cash flow can be obtained from cash flow statements only. Cash flow statements does not talk about profits or loss, instead it gives idea to shareholders that how company is managing its cash flow (cash in & cash out). For any industry, regular payments to vendors, employees, creditors etc are most important for long term standing. Cash flow statements tells us from company is generating its maximum cash. In general cash requirements of any company can be classified into three sections:
(1) Cash Requirement One : Operating activity (to run its day to day work)
(2) Cash Requirement Two : Investing activity (Capex, investment, mergers, acquisitions)
(3) Cash Requirement Three : Financing activity (debt payment, stock issue, stock buyback)
In cash flow statements it is highlighted that if these individual activity is generating enough cash for itself or they need cash from others to meet their requirements. Out of these three classifications, operating cash does the major chunk of business. If a company is able to manage a positive operating cash flow in long term (10-15 years) in succession, it means the managers has managed well. Mind it we are not talking about profits, but only about cash requirements (cash out Vs. cash in)
Actual cash in hand an important for doing business
Suppose a company has done a sales worth $10 million dollars. Does it mean that the company has $10 million dollars of cash in hand to pay its debtors? The answer is No, because unless the goods or services on COD (cash on delivery) basis, it is not possible to have cash soon after sales. In companies income statement the transaction can be recorded as ‘sale made’ but physically the cash has not flown in. Suppose the goods was sold on 60days credit terms, it means $10 million dollars will come after 60 days from the date of selling.
This makes it a herculean task for the managers to manage the cash flow. Depending on the payment terms from customer (60 days credit), the vendors shall also allow purchase (by company) on 60days credit to more.
Operating cash flow catch such defects of income statements. It only list down that cash which has actually flown in the company (payments received Vs. payments actually made). If payments collected from customer (sales) is more than the payments made to vendors etc (operating expenses), then operating cash flow will be positive. Even though company is making losses, but it is able to manage the cash flow as positive, then company can still survive.
There are some very daunting examples of companies which showed healthy profits in their income statements but their cash flow statements was all red. Eventually all these companies were declared bankrupt. PEG (Growth in Earnings per share, EPS) over a period of time is one aspect that investors must consider for sure, but while considering EPS, investors must not forget to check the operating cash flow in the cash flow statements. Cash flow statements will say it company is moving towards bankruptcy.
Conclusion
Maintaining positive operating cash flow is the heart of companies performance parameter. On day to day basis this is the only parameter that companies managers try to manage. You must have often heard managers working hard to maximize the collections as per their quarterly targets. Top managers knows that if they are able to maintain a positive operating cash flow as positive then 90% job is done.
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