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Operating Cash Flow

Financial Statements

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Operating Cash Flow represents the flow of cash into or out of the business based on their “operations”. This represents all the common day to day actions associated with the business. Look at Operating Cash Flow to see if cash flow from the business model is positive or negative. If positive, the business creates more cash than is needed for its basic functions. If negative, the business is losing money from its day to day operations. This means the business is acquiring cash from elsewhere to carry its negative operations: previously retained earnings, income from investments, or cash from financing. At some point, the company will be forced to earn positive cash flow from operations or go out of business. Consistently negative cash flow from operations always leads to bankruptcy.

Operating Cash Flow starts with Net Income, derived from the income statement. All adjustments are then added to or subtracted from net income until the final line of the Cash Flow Sheet, Net Increase or Decrease in Cash Flow.

There are two adjustments that must be made to Cash Flow to strip away non-cash charges from net income. Depreciation and amortization are added back to Cash Flow. Allowing depreciation and Amortization to remain in net income would muddle cash flow from operations with non-cash charges. Cash never enters or exits due to these values.

Changes in working capital

Operating Cash Flow consists of measuring the effects of typical business operations. There are two methods to display Cash Flow from Operations. The Direct method displays the detailed record of cash flows. The indirect method displays only a single figure for Cash Flow from Operations. An increase in cash flow is shown by a number standing by itself or with a plus sign beforehand. A decrease is shown by a number surrounded by parenthesis or a minus sign.

The following create a +increase or a (-decrease) in Cash Flow.

 +Decrease (-Increase) in Accounts Receivable

A decrease in cash flow related to Accounts Receivable indicates that payments were made to the company. This excludes write-offs. Since Accounts Receivable is what the company is owed, decreases in this category only occur when payments are made in cash.

 +Decrease (-Increase) in Inventories

An increase in cash flow related to inventory shows that inventory was sold and cash is entering the business. An increase in inventories shows that sales have slowed and inventory is stacking up or the company is creating an inventory to sell in the future. In both cases, cash flow is decreasing relative to the last period.

 +Decrease (-Increase) in other Assets

A decrease in cash flow related to assets indicates that assets related to the company’s operation have been sold. In exchange, cash is entering the business. Increases in asset related cash flow indicate that the company is purchasing assets, or building them from scratch. Cash is flowing out of the business in order to create or configure these assets for the company.

 +Increase (-Decrease) in Accounts Payable/Current Liabilities

An increase in cash flow related to accounts payable or current liabilities indicates the company has either purchased on credit or has acquired a short term loan. If the firm has purchased on credit, they have avoided paying their money and creating an outflow… until the loan is due. If the firm acquired a short term loan, Cash flows into the company as a result of the loan. Decreases in accounts payable or current liabilities indicate cash is leaving the company as debts are paid off. This outflow of cash decreases cash flow.

 +Cash provided (-Used) by Operations

After all non-cash adjustments and working capital adjustments are made to net income, Cash Flow provided or used by operations is displayed. Operating Cash Flow is best when positive and very high. You should look at Operations Cash Flow when seeking companies to invest in. This determines if the company will be able to make investments that will generate future revenue or pay off dividends to stockholders. If your target firm has decreasing or negative Operating Cash Flow, this is a huge warning sign. You should avoid the company until this problem is fixed.

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