What’s Operating Cash Flow?
Operating cash flow (CFO) represents the amount of cash that a business has generated from its day-to-day operations within a measured time period. The operating cash flow figure of a company can be found within the firm’s cash flow statement under the line item that is often referred to as “cash from operational activities”
Just like any other cash flow measure, a company’s operating cash flow will usually differ from its earnings or net income. This is because cash flows, in general, track the actual net amount of cash in and outflows within a business, whereas earnings represent the firm’s profits based on the principles of accrual accounting.
How Is Operating Cash Flow Calculated?
Since a company will always report its own operating cash flow within its cash flow statement, you will usually not have to calculate it for yourself. Though, it may be crucial to know how CFO is computed in order to understand and evaluate what can cause negative operating cash flows in the first place.
The formula for operating cash flow goes as follows:
Net income is the starting point of any cash flow statement and represents the net accounting profits that a company generated during a measured time period. The net income of a firm differs from actual cash flows as a result of different accounting adjustments, which is why those adjustments have to be reverted in order to determine the actual cash flows of the company.
Non-Cash Charges are all kinds of expenses that aren’t actually cash costs but were previously deducted to arrive at net earnings. Primary examples of non-cash charges are depreciation and amortization.
Changes in WC are either increases (that are cash outflows) or decreases (which are cash inflows) of a firm’s working capital. Working capital is essentially the actively operating capital that a business needs in order to keep its operating cycle in motion. Working capital is defined as the difference between current assets and current liabilities which can both be found in a company’s balance sheet. To calculate the change in WC, subtract the firm’s previous working capital from its current working capital.
Note that a firm’s reported operating cash flow will mostly differ from the calculation used with this formula since there will be different types of non-cash charges and WC adjustments that are specific to the circumstances of the company.
What’s Negative Operating Cash Flow?
A negative operating cash flow reflects the fact that a company has not been able to generate real positive cash flows from its operations within the measured time period. There are several causes that can lead to a negative CFO with the most common one being negative earnings.
What Can Cause a Negative Operating Cash Flow?
Negative operating cash flows can only occur when (1) the company’s net income was negative in the first place or (2) when the firm faced a substantial increase in its working capital which was higher than the sum of net income and non-cash charges during the measured time period.
The second scenario also suggests that in some cases a company can have positive net income but negative operating cash flow. An example for that will follow below.
Example 1 - Negative CFO as a Result of Negative Net Income
Cloudflare, Inc. is a cloud-based company that provides software security options to businesses on a global scale.
Since Cloudflare is a relatively young but rapidly growing business, the company still hasn’t generated positive earnings yet. In its fiscal year of 2020, Cloudflare reported a negative net income of -$119 million.
As a result of the negative earnings, the company’s operating cash flows were negative as well.
Example 2 - Negative CFO Because of an Increase in Working Capital
Array Technologies, Inc. produces solar tracking systems and sells them to corporations, businesses, and private homes. In 2020, the company reported a net income of approximately $59 million, whereas its operating cash flow was -$122 million as a consequence of the significant increase in working capital which was primarily driven by a decrease in deferred revenues compared to 2019.
How Do You Evaluate Companies With Negative Cash Flows?
In general, a negative operating cash flow isn’t a positive sign to begin with since that indicates that the firm may not be able to generate and maintain enough cash to carry on and grow its operations on a sustainable basis without raising additional capital from debt or equity.
That being said, negative operating cash flows aren’t necessarily uncommon for young businesses or companies in temporary financial distress. Therefore, the first sensible thing to do when assessing a firm with negative operating cash flows would be to point out the exact reason that led to the negative CFO.
Was it bluntly the unprofitability of the firm that resulted in negative cash flows as well? Or did a substantial increase in working capital exceed and negate positive earnings?
- If the company was unprofitable, it would be worth determining whether the firm’s unprofitability was caused by temporary circumstances, poor operational efficiency, or lasting financial distress. Having a look at other financial metrics such as operating margins, revenue growth, and return on capital (ROIC) can give further insights into the firm’s usual performance trend.
- When an increase in WC resulted in negative cash flows, the firm will usually specify the exact reason in its annual report or 10-K. Learning about the discrete circumstances which forced the company to increase its working capital during the measured time period can be crucial in order to judge whether it will occur again or not.
In either way, solely relying on operating cash flows as the only to assess a firm’s performance will mostly be insufficient to get a complete picture of the company’s current financial health and its future capabilities to increase long-term shareholder value.
Operating cash flow is one of the crucial indicators of a firm’s current financial performance as it represents the amount of net cash that can be generated from its operations. A negative operating cash flow can only occur due to negative earnings or a considerable increase in working capital during the given time period.
There is not one straightforward approach to assessing a business with negative CFO: Two entirely different companies can prevail in very diverse circumstances, especially when they’re not operating within the same industry. Since cash flows are critical measures of financial health, the objective should generally be to gauge how long and sustainable the company can afford negative cash flows until it will generate excess value.