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Showing posts with label Operating Cash Flows. Show all posts
Showing posts with label Operating Cash Flows. Show all posts

Wednesday, July 7, 2010

Understanding Operating Cash Flows

Cash is king - or queen if you wish. In either case, without cash a company can’t exist for long.

While that statement may seem obvious, too many investors focus solely on numbers like net income and earnings per share and ignore operating cash flow.

Operating cash flow (OCF) is not the same thing as net income, but is derived from net income through a series of adjustments to working capital accounts on the balance sheet. This is an accountant’s way of saying that OCF details how cash flows into and out of a company. If more flows in than out, the flow is positive, if not, the flow is negative.

Positive Earnings

A company could report positive earnings and still be suffering negative OCF. If a company is regularly spending more cash than it is taking it, something is obviously wrong.

This is one of the differences between accrual accounting and cash accounting. Without going into a detail explanation, accrual accounting, which is what companies use, allows companies some flexibility in how and when they record income and expenses.

This may obscure short-term problems such as burning cash, however sooner or later the company will have to face the basic issues that are causing the cash drain.

Investors

For investors, studying the operating cash flow will help you spot companies that are burning cash faster than they are taking it in regardless of what their net income or EPS numbers might be.

For those investors who like to get their hands dirty, you can find the operating cash flow on the statement of cash flows in a company’s balance sheet. You are looking for a positive number or some temporary reason for a negative one.

Another way to get at the information is to use the Price-to-cash flow ratio. You calculate the Price/Cash Flow like the other metrics using the stock price; however, the important factor here is a positive number.

The handy feature of the Price/Cash Flow is you can use it in screening stocks. This allows you to eliminate cash burners from consideration before you get started. You can also compare a company to its peers for an idea of how it is doing.

Operating Cash Flow (OCF) is not perfect. There are some ways it can be manipulated; however, it is a strong tool for your consideration. Like all tools, it is not the only one you should use, but it will sound a warning if you get too close to a cash burning company.