Operating Cash Flow#

Operating cash flow (OCF) is the cash generated from running the core business. It's the most important number on the cash flow statement because it shows whether the business model actually produces cash.

Operating cash flow answers the fundamental question: Does this business generate cash from its operations? If the answer is consistently "no," the company has a serious problem regardless of what other metrics show.

The Indirect Method Explained#

Most companies present operating cash flow using the indirect method, which starts with net income and makes adjustments.

Step 1: Start with Net Income#

Net income from the income statement is the starting point. It's the profit calculated using accrual accounting.

Step 2: Add Back Non-Cash Expenses#

These items reduced net income but didn't actually use cash:

Non-Cash Expense	Why Add Back
Depreciation	Asset cost spread over time—no current cash
Amortization	Intangible asset write-off—no current cash
Stock-based compensation	Paid in stock, not cash
Deferred taxes	Tax expense recorded but not yet paid
Impairment charges	Asset write-downs—no cash involved

Step 3: Adjust for Working Capital Changes#

This is where the reconciliation gets interesting. Changes in current assets and liabilities affect cash:

Change	Effect on Cash	Logic
Receivables increase	Subtract	Sold but didn't collect cash
Receivables decrease	Add	Collected cash from prior sales
Inventory increase	Subtract	Bought inventory but didn't sell
Inventory decrease	Add	Sold inventory without buying more
Payables increase	Add	Received goods/services but didn't pay
Payables decrease	Subtract	Paid for prior purchases

Memory Trick

For current assets: Increase = Subtract (cash used), Decrease = Add (cash released) For current liabilities: Increase = Add (delayed payment), Decrease = Subtract (paid out)

Complete Example#

Line Item	Amount
Net Income	$1,000,000
Adjustments:
Add: Depreciation & Amortization	$200,000
Add: Stock-based Compensation	$50,000
Working Capital Changes:
Increase in Accounts Receivable	($150,000)
Decrease in Inventory	$75,000
Increase in Accounts Payable	$100,000
Decrease in Accrued Expenses	($25,000)
Cash from Operating Activities	$1,250,000

In this example, operating cash flow ($1.25M) exceeds net income ($1M)—a positive sign of high-quality earnings.

Operating Cash Flow vs. Net Income#

Comparing OCF to net income reveals earnings quality:

The Ratio#

OCF to Net Income Ratio = Operating Cash Flow ÷ Net Income

Ratio	Interpretation
> 1.0	High quality—more cash than profit
≈ 1.0	Normal—cash roughly matches profit
0.5 - 1.0	Monitor—cash below profit
< 0.5	Concern—investigate working capital
Negative	Red flag—profits not converting to cash

Consistent Divergence

One quarter of OCF below net income isn't necessarily alarming. But if the pattern persists over multiple periods, dig deeper into why profits aren't becoming cash.

Working Capital Analysis#

Working capital changes can significantly impact cash flow.

Why Working Capital Matters#

Growing companies often see cash consumed by working capital:

More sales = More receivables (waiting for payment)
More sales = More inventory (anticipating demand)
These uses of cash can exceed net income

The Working Capital Cycle#

Cash → Inventory → Receivables → Cash
     (buy)      (sell)      (collect)

The faster this cycle turns, the less cash is tied up.

Days Outstanding Metrics#

Metric	Formula	What It Shows
Days Sales Outstanding (DSO)	(Receivables ÷ Revenue) × 365	Days to collect from customers
Days Inventory Outstanding (DIO)	(Inventory ÷ COGS) × 365	Days inventory sits before sale
Days Payables Outstanding (DPO)	(Payables ÷ COGS) × 365	Days to pay suppliers

Cash Conversion Cycle = DSO + DIO - DPO

Lower is better—it means cash cycles through faster.

Quality of Earnings Assessment#

Use operating cash flow to assess whether earnings are "real":

High-Quality Earnings Signs#

OCF consistently exceeds net income
Stable or improving OCF-to-NI ratio
Reasonable working capital growth relative to revenue
Cash flow supports dividend payments

Low-Quality Earnings Signs#

OCF consistently below net income
Declining OCF-to-NI ratio
Receivables growing faster than revenue
Inventory building without sales growth
Cash flow insufficient for basic operations

The Accrual Reality Check: Accrual accounting allows companies to record revenue before collecting cash and to delay expense recognition. Operating cash flow strips away these accounting choices and shows the cash reality.

Industry Considerations#

Different industries have different OCF patterns:

Industry	Typical OCF Pattern
Software/SaaS	OCF often exceeds NI (low working capital needs)
Retail	Seasonal OCF swings around inventory
Manufacturing	OCF may lag NI due to inventory/receivables
Construction	Project-based OCF can be lumpy
Subscription	Very predictable OCF patterns

Analyzing Trends#

Look at operating cash flow over multiple years:

Year	Net Income	OCF	OCF/NI Ratio
2022	$50M	$60M	1.20
2023	$65M	$55M	0.85
2024	$80M	$45M	0.56

This company shows a concerning trend: net income is growing, but operating cash flow is declining. Something is consuming cash—possibly receivables, inventory, or deteriorating business fundamentals.

Red Flags in Operating Cash Flow#

Red Flag	Possible Cause
Negative OCF with positive net income	Aggressive revenue recognition, collection issues
OCF declining while NI grows	Working capital problems, earnings manipulation
Large adjustments for non-cash items	Heavy stock compensation, impairments
Frequent "one-time" cash charges	May be recurring costs

Key Takeaways

Operating cash flow shows cash generated from core business
The indirect method starts with net income and adjusts for non-cash items and working capital
Compare OCF to net income to assess earnings quality
OCF greater than net income suggests high-quality earnings
Working capital changes can consume significant cash in growing companies
Watch for divergence between OCF and net income over multiple periods
Different industries have different typical OCF patterns