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January 9, 2007
Operating Cash Flow
Successful Companies and the Money They Spend
For the human being, there are the basic necessities of life: food, water and shelter. In reality, it is similar in the business world. A company has one basic necessity; in order to survive, a company must have cash. A company without cash is like a human without water; neither will be able to exist very long. Successful traders need to be able to see whether a company is healthy or dying and its operating cash flow is a prime indicator for review. Operating cash flow isn’t the same thing as net income, but it is derived from net income through a series of adjustments to working capital accounts on the balance sheet. In other words, operating cash flow monitors the surge of cash in and out of a company. If more cash is flowing in, the flow is positive, if not, the flow is negative.

Why are you negative if the earnings are positive?
A company can actually report positive earnings and still be suffering negative operating cash flow. This is a signal for the investor; if a company regularly spends more cash than it takes in, additional technical analysis is needed. It is important to remember this can be a short-term situation, such as an acquisition, or it can be the sign of problems within a company.

As scandals such as Enron have shown, the financial numbers of a company can be “polished” so that they appear to reflect a positive outcome. With legislation such as Sarbanes – Oxley, however, the government has attempted to eliminate this form of inaccurate reporting so that an investor can truly know and understand the earnings and determine the operating cash flow of a company. The hope is to force companies to accurately report earnings and keep negative Wall Street news to a minimum. 

Studying the Tides
For investors, understanding operating cash flow is a little like watching the tides of the ocean. The tide comes in, the tide goes out…but there’s a big difference in the business world. Unlike the ocean, the cash flowing in and out of a company can vary greatly and it can be very difficult to spot as well. An investor can use the operating cash flow to look for situations where a company doesn’t have enough cash coming in to meet its expenses. Fundamental analysis of such a company is required to understand if this is temporary or a chronic problem.

Conclusion
For investors, operating cash flow is one excellent measure of the health of a company. Since it is never wise to rely on only one metric, reviewing operating cash flow for previous years, calculating cash flow ratios or earnings per share can also be extremely helpful in obtaining an accurate picture of the fiscal health of a company. It is also possible to use the price to cash flow ratio; P/CF can also be used in stock screeners to eliminate companies that burn cash and increase your chances of successful trading. Operating cash flow is not a perfect measurement and should not be relied on solely for making decisions on stock purchases. It can be manipulated and should only be one the metrics used by a savvy investor to identify companies for potential purchase. Always remember that for a company, cash is a necessity of life!


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posted by Stephen W. Bigalow at 9:53 PM     EMAIL TO A FRIEND

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