Whether you run a  private company or an investor in the stock market- you should know that operating cash flow (OCF) is the lifeblood of the company.  While investors and business owners often consider net income as their key indicator, OCF is a much better choice to monitor the enterprise’s financial health.  Why?  Because OCF is a little harder to manipulate (but, of course, it can be done).  Secondly, without cash, the company dies.

Here’s where the definition is key:  OCF is the cash flow provided from operations, it is different from EBITDA (earnings before interest, taxes, depreciation, and amortization). It is defined as EBIT (obviously, earnings before interest and taxes) + Depreciation – “ Taxes.  (OCF= EBIT + Depreciation – Taxes.) EBITDA can be affected by financing and capital investment decisions;  OCF will not. OCF is strictly a function of net income and changes to working capital (i.e., current assets-current liabilities).

[There are two other cash flows which are not discussed today:  Investment cash flow (net cash resulting from capital expenditures, investments, and acquisitions) and financing cash flow (net cash due to raising cash to fund other flows or repay debt). ]

This is where the differences between accrual and cash accounting become obvious. Assuming you were on accrual accounting, you use cash to produce (manufacture or acquire) inventory.  When that inventory is sold, you create an account receivable (unless you customers pay you immediately upon delivery; usually not true). When your customer pays your account receivable (decreasing it), you develop cash.  So, if you are building up inventory, you have less cash.  If you customers pay you slowly, you have augmented receivables and less cash.

If a company is public (or about to become so), there are many opportunities to seemingly increase net income.  (This is done to increase the stock price or for executives to earn bigger bonuses, which are typically tied to net income and/or stock prices.)  One of the more common “cheats” is when the company provides the retailer with extended payment terms and/or a promise to take back the inventory if it doesn’t sell. This process books sales and increases accrued earnings (with NO changes to the company’s cash). This actually steals sales from one or two quarters hence- which is how companies tend to look good for short-term periods (and then fall apart).

The key point is when operating cash flow is much smaller than net income, there is something wrong. One should examine the inventory levels and receivables to determine if this is a short- or long- term issue.

You will recall I said you can manipulate OCF, too.  One of the ways to do so has been rampant during this Great Recession- payments get delayed to suppliers.  This means there is an increase to the accounts payable, as well as to cash (since it has not been spent).  Another approach (this is often used in the health care industry) is to restructure the reserves for the firm (cash held for self-insured portions of malpractice or other purposes).

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