Basic Accounting

Continuing our discussion on cash flow 101, I feel that cash flow discussion is not complete without digging further into operating cash flow. To refresh your memory, operating cash flow is the cash flow generated by a firm’s business activities. Business exists to produce cash flow. Therefore, we prefer business that spots a positive cash flow.

We do invest in companies that produce negative cash flow in certain ocassions. For example, this is the company that is growing rapidly and in order to create barrier of entry, the company is investing heavily while business hasn’t picked up. An example of this scenario is: biotech companies that spend money on Research & Development or retailers giving away free shipping to gain customer loyalty.

There is also a little thin line of classifying expense of between operating cash flow and say investing cash flow. A retailer that is giving away free shipping might experience a positive operating cash flow but negative investing cash flow if it feels that the free shipping is a long term investment to create barriers of entry. However, for the most part, that kind of expense will fall into operating cash flow since it relates to the daily part of the company’s business.

Now, what constitutes a positive cash flow from operations? Generally, we work our way back from the income statement. From the net income, we have to add depreciation and amortization, interest expense and taxes. This is because, theoretically, a firm is not required to pay taxes if it reported a net loss. Furthermore, interest expense is deemed to vary depending on a firm’s capital structure. A firm may pay more or less interest expense due to the amount of debt it holds, not due to its operating efficiencies. Finally, depreciation and amortization is the subtraction of long term asset purchased outside of the accounting period. Therefore, no cash actually flows out of the coffer during the period.

Let’s take a look at a typical cash flow statement for Merck & Co Inc. (MRK). For the fiscal year ending on December 2006, Merck reported net income of $ 4.34 Billion. Operating cash flow meanwhile, was reported at $ 6.77 Billion, mainly due to $ 2.27 Billion addition of depreciation. There is also adjustments due to change in liabilities and/or inventories as well as account receivables. That is a given. When you do X amount of sales but you did not get cash back (a.k.a bulging account receivables), your operating cash flow would be affected. There is also a line called ‘Adjustments to Net Income’, which is not clear from the example above. For the most cases, however, cash flow generated from operation is a higher figure than the net income figure.

Now, how would cash flow from operations help us in investing in stocks? In the absent of dependable cash flow from operations, we prefer to invest in companies that have positive net cash on their balance sheet. This means more cash on hand than it has debt. If a firm has dependable huge cash flow from operations, it can compensate for the lack of strength in its balance sheet (i.e: less cash than long term debt).

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