Operating Cash Flow

Operating Cash Flow (OCF) measures the cash generated from a company's normal business activities. It excludes investing activities like buying equipment and financing activities such as issuing stock or debt. The formula is Net Income plus Non-Cash Expenses plus Changes in Working Capital.

When calculating OCF, certain items are added back to net income: depreciation and amortization, stock-based compensation, deferred taxes, and decreases in receivables or inventory. Items that reduce OCF include increases in receivables, increases in inventory, and decreases in payables.

For example, if a company has $100 million in net income, adds back $20 million in depreciation and $5 million in stock compensation, subtracts $10 million for increased accounts receivable and $5 million for increased inventory, then adds $10 million for increased accounts payable, the resulting operating cash flow would be $120 million.

When comparing OCF to net income, healthy companies typically have OCF greater than net income. If OCF is consistently below net income, it may indicate aggressive accounting practices. A growing gap between the two is a red flag.

Several coverage ratios help analyze cash flow health. OCF divided by revenue shows cash efficiency. OCF divided by net income indicates earnings quality. OCF divided by total debt measures debt coverage ability.

OCF matters for several reasons. It shows sustainability by revealing whether the company can fund itself. It indicates quality by showing if earnings are backed by actual cash. It demonstrates flexibility by showing available cash for opportunities. It proves solvency by confirming the company can pay bills and debt.

Red flags to watch for include OCF consistently below net income, negative OCF in a mature company, a declining OCF trend, and high working capital buildup.

For effective OCF analysis, compare OCF to net income over time rather than just one period, check the trend direction, understand what's driving working capital changes, consider industry-specific capital requirements, and calculate OCF margin by dividing OCF by revenue.