Operating cash flow

What it means

Operating cash flow is the cash a company generates from its ordinary activities. It starts from profit, adds back depreciation and other non-cash costs, and adjusts for changes in receivables, inventory and payables. It shows whether the business funds itself.

It is the first and most important section of the cash flow statement. Unlike the operating result it captures the real movement of money: an invoice issued in December and paid in March raises this year's profit, but the cash arrives only next year.

Operating cash flow drives free cash flow, from which loans are repaid and dividends paid. A company that reports a profit year after year but negative operating cash flow is funding growth with debt or owner contributions and will sooner or later run into a liquidity problem.

How it works in practice

It is most often calculated by the indirect method from profit after tax. Depreciation is added back, increases in receivables and inventory are deducted, and an increase in trade payables is added. The direct method adds up actual receipts and payments and is often easier to follow in small firms.

Fast growth is dangerous for operating cash flow. More orders mean more receivables and stock that must be paid for before customers pay the company. Managing working capital and the cash conversion cycle therefore matters as much as margin does.

When assessing a loan, banks compare operating cash flow with the annual repayments. EBITDA is only a rough proxy for it, because it ignores changes in working capital and the tax actually paid, both of which can cut cash significantly.

What to watch out for

One-off effects distort the picture. Delaying supplier payments until year end improves operating cash flow for a moment, but it comes back with the opposite sign in January. When judging a company it pays to look at several periods together.

Items must be classified consistently between operating, investing and financing activities. If interest paid is shown as operating one year and as financing the next, year-on-year comparison loses its meaning and an analyst may draw the wrong conclusions.