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What is Operating Cash Flow?
Operating cash flow (OCF) is the cash a company generates from its normal business operations. It is one of the most important measures I use to evaluate the financial health and value of a business.
Operating cash flow appears on the Statement of Cash Flows, which separates a company’s cash flows into three categories:
- Operating activities
- Investing activities
- Financing activities
This separation allows investors to see how much cash the company’s core business actually generates before considering investments such as capital expenditures and financing decisions such as borrowing, repurchasing shares, or paying dividends.
Why Operating Cash Flow Matters
A profitable business does not necessarily generate strong cash flow.
Accounting earnings include numerous noncash expenses and accruals. Operating cash flow helps investors look beyond reported earnings and determine how much cash the underlying business is actually producing.
Over the long term, a healthy business must generate sufficient operating cash flow to fund its operations and provide capital that can ultimately be used for:
- Capital expenditures and future growth
- Debt and interest obligations
- Dividends
- Share repurchases
- Acquisitions
A company that consistently fails to generate adequate operating cash flow must eventually obtain cash elsewhere, such as by borrowing money, selling assets, or issuing additional equity.
Operating Cash Flow Calculation
Most companies report operating cash flow using the indirect method, which begins with net income and adjusts for noncash expenses and changes in operating assets and liabilities.
A simplified calculation is:
Operating Cash Flow = Net Income + Noncash Expenses ± Changes in Working Capital and Other Operating Adjustments
Noncash expenses can include depreciation, amortization, and stock-based compensation.
Working-capital adjustments can include changes in:
- Accounts receivable
- Inventory
- Accounts payable
- Other operating assets and liabilities
For example, a company may report a sale as revenue before it actually collects the cash. The increase in accounts receivable must therefore be accounted for when converting reported earnings into operating cash flow.
Operating Cash Flow vs. Free Cash Flow
Operating cash flow and free cash flow measure different things.
Operating cash flow measures the cash generated by the company’s operations.
Free cash flow (FCF) generally takes operating cash flow and subtracts capital expenditures:
Free Cash Flow = Operating Cash Flow − Capital Expenditures
Free cash flow is extremely useful because it estimates how much cash remains after the company makes the capital investments necessary for the business.
However, capital expenditures can fluctuate substantially from year to year. A company may temporarily increase capital spending to build a factory, expand capacity, modernize equipment, or make other long-term investments. That can sharply reduce current free cash flow even when the underlying business remains healthy.
This is one reason I pay particularly close attention to operating cash flow when analyzing a company’s underlying earning power.
Operating Cash Flow Per Share
For stock analysis, I frequently convert operating cash flow into a per-share figure:
Operating Cash Flow Per Share = Operating Cash Flow ÷ Diluted Shares Outstanding
Operating cash flow per share allows investors to compare the cash-generating ability of the business with the market price of each share.
For example, if a company generates $10 of operating cash flow per share and its stock trades for $150, investors are paying approximately:
$150 ÷ $10 = 15 times operating cash flow
That valuation can then be compared with the company’s historical valuation, financial strength, growth prospects, business quality, and the valuations of similar companies.
Why I Use Operating Cash Flow in Valuation
No single financial metric should determine what a company is worth. Earnings per share, free cash flow, the balance sheet, profitability, growth, and business quality all matter.
But operating cash flow per share is one of my primary valuation metrics because it provides a useful measure of the cash-generating power of the underlying business without being as directly affected by fluctuations in capital expenditures as free cash flow.
The objective is not simply to find companies generating a lot of cash. It is to determine how much cash the business can sustainably generate and how much an investor should be willing to pay for it.
That distinction is at the heart of fundamental investment analysis.
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