In business, the ability to generate cash is perhaps the most important thing. Cash flow helps investors understand a company’s financial health and future prospects, and estimate how much return they could make over the long or short term.
In this article, we’re going to understand operating cash flow (OCF), the OCF ratio, its limitations and interpretations, and how to make better equity investment decisions with OCF.
What is operating cash flow (OCF)?
Operating cash flow is the net cash that is generated by a business as a result of its normal, day-to-day operations. OCF is usually calculated for one specific period – this could either be a financial quarter or year.
Operating cash flow answers the question, “Is the business generating enough cash from its core activities to cover its operating expenses and maintain its operations?”
There are two ways of estimating the OCF of a company:
- The direct method using net income – To estimate the OCF of a company, you could work your way up the income statement with net income, adjust it for non-cash expenses like D&A, and changes in working capital.
- The indirect method using revenue – The indirect and perhaps simpler method to estimate OCF is to work your way down the income statement from revenues, and deduct all cash expenses like cost of sales, and selling, general, and administrative expenses (SG&A).
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What is the OCF ratio?
The OCF Ratio compares a company’s operating cash flow to its current liabilities. It signifies the company’s ability to pay off its short-term debts using the cash directly generated from its core operations. Here’s the formula:
OCF Ratio = Operating Cash Flow / Current Liabilities
Understanding the ratio
These are some rules of thumb to keep in mind:
- A ratio greater than 1 indicates the company generates sufficient cash flow to cover its current liabilities, suggesting short-term stability and solvency.
- A ratio close to 1 suggests the company might have just enough cash flow to meet its short-term obligations, requiring close monitoring and budgeting.
- A ratio less than 1 usually raises concerns about the company’s ability to pay off its current liabilities with the cash it is currency generating.
Limitations of the OCF ratio
OCF ratio, as a metric, is not used as widely as other solvency metrics like the quick ratio or the current ratio because:
- It depends heavily on specific industries. This is a problem because the acceptable range for the OCF ratio isn’t a one-size-fits-all numeral; while one ratio could signal possible insolvency issues in one company, the same ratio could be the norm in the other.
- Capital expenditures aren’t included in the OCF calculation, which means that a company might be heavily financing long term capital expenditures with its operating cash flow. Even though this represses the OCF in the short run, it potentially increases cash flows in the long term.
Also Read: Interest coverage ratio – A practical guide
Additional considerations
When analysing equity using OCF, here are a few other things you must keep in mind:
- Cash flow drivers are just as important as the actual cash. Try to understand the story behind a company’s OCF, such as pricing strategies, inventory management, and customer payment cycles.
- Think long term because OCF indicates short term solvency but does nothing to indicate the health of a company in the long run. Companies, as well as investors, need to consider the former’s ability to generate cash flow over the long term to support future growth and debt repayment.
- Studying the management team could also help in identifying their goals and why they’re using their cash the way they are. This could be for investments, debt reductions, or dividends, depending on the particular company.
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Difference between the current ratio and the operating cash flow ratio
Here are some main differences between two popular short-term solvency ratios:
| Feature | Current Ratio | OCF Ratio |
| Focus | Measures a company’s ability to pay its short-term debts using its current assets. | Measures a company’s short-term ability to meet current liabilities using cash generated from its core operations. |
| Components | Current assets (cash, inventory, accounts receivable) / Current liabilities (accounts payable, short-term debt) | Operating Cash Flow (derived from net income + non-cash adjustments) / Current liabilities |
| Time Horizon | Snapshot of financial position at a specific point in time (usually end of the accounting period). | Reflects cash flow generation over a specific period (fiscal quarter or year). |
| Accounting Treatment | Subject to accounting standards and policies. Can be influenced by accrual accounting. | More closely reflects actual cash flows. Less prone to accounting manipulation. |
Conclusion
While OCF or the OCF ratio both succeed in providing a measure of a company’s short-term solvency, they fail to take into account the internal potential of the company to generate greater future cash flows, or the importance of the economic environment.
Just like with any other financial metric, your analysis will get more accurate with more metrics to support your decision, not less. With that in mind, good luck!
