Can someone explain me a few things about operating cash flow?

[reaz]

So I've read that a rise in net income combined with a decline in operating cash flow indicates a declining value in the company shares.

However, there was no real explanation. It seems the author was too tired to explain this. Now I'd like you to post the reasoning for this phenomena. Why is it so?

[SKYHIGH]

So I've read that a rise in net income combined with a decline in operating cash flow indicates a declining value in the company shares.

However, there was no real explanation. It seems the author was too tired to explain this. Now I'd like you to post the reasoning for this phenomena. Why is it so?

Hi,
Great thought.
As we all know the cash flow consists of three different major categories of business areas. Though, the most important and prominent one is cash flow generated from operation, where business main operation is generating sufficient cash flow to fulfill current obligation (e.g. dividend payables). For example, acid test ratio below industry average represents company technical inconveniency.
Although, company is producing quite enough income available for shareholder, however, does not have enough cash to pay dividend may signify another form of insolvency.
We follow accrual based accounting system, where we match expenses with revenues, and we recognize income before we realize it. In simple words income will be recorded regardless of cash collection. In this case net income can be shown inflated where net cash flow will not be available to distribute it to shareholder if declared. So, if company is short of cash but abundance in net income will not declare dividend consequently the share price will go south. As we know, share value is directly proportionate to dividend growth.
Salaam
Sky

[reaz]

Hi,
Great thought.
As we all know the cash flow consists of three different major categories of business areas. Though, the most important and prominent one is cash flow generated from operation, where business main operation is generating sufficient cash flow to fulfill current obligation (e.g. dividend payables). For example, acid test ratio below industry average represents company technical inconveniency.
Although, company is producing quite enough income available for shareholder, however, does not have enough cash to pay dividend may signify another form of insolvency.
We follow accrual based accounting system, where we match expenses with revenues, and we recognize income before we realize it. In simple words income will be recorded regardless of cash collection. In this case net income can be shown inflated where net cash flow will not be available to distribute it to shareholder if declared. So, if company is short of cash but abundance in net income will not declare dividend consequently the share price will go south. As we know, share value is directly proportionate to dividend growth.
Salaam
Sky

Ah I see. So basically what I gather from this is that an increasing net income combined with a declining operating cash flow means that the net income is inflated or that it's not being distributed to the shareholder because the company lacks cash.

Also what I gather is that net income is not a true indicator of whether the share value is going to rise or not because it's dependent on how the accounting works and that it can be inflated on purpose. So comparing the operating cash flow will give a better indication.

Can you tell me what the formula for operating cash flow is with respect to gross income? or is there such a formula?

Thanks.

[bender]

I don't know if you know this already, but it's cash flow that is important when valuing a company not profits.

[reaz]

I don't know if you know this already, but it's cash flow that is important when valuing a company not profits.

I wasn't aware of this. I am a noob when it comes to reading financial reports. I've picked up a book on financial statements. Hopefully, I'll come out with a better understanding of financial statements at the other end.

Though I'll probably also need to study up financial statement analysis if the book does not go into details about analysing securities based on their financial statements.

[SKYHIGH]

Ah I see. So basically what I gather from this is that an increasing net income combined with a declining operating cash flow means that the net income is inflated or that it's not being distributed to the shareholder because the company lacks cash.

Also what I gather is that net income is not a true indicator of whether the share value is going to rise or not because it's dependent on how the accounting works and that it can be inflated on purpose. So comparing the operating cash flow will give a better indication.

Can you tell me what the formula for operating cash flow is with respect to gross income? or is there such a formula?

Thanks.

There are direct and indirect methods. In short direct method is income statement based on cash not accrual. On the other hand indirect cash flow calculation starts from net income and we adjust non cash item in it (for example amortization and working capital).

Ok don’t take example of dividend payable, take wages payable if we don’t have cash to pay them so what is going to happen. On the other hand if short term obligations are due and there is no cash available then it is certain company is technically insolvent. A company which is not fulfilling short term obligation then shareholders won’t have any reason to rely on that company and stock price will go up.
Accountants can inflate net income very easily. Only increase in production leads to increase in ending inventory which will cause increase in net income.
Net income is no way a leading indicator to assess company performance.

SKY

[nazimhamed]

:dunno: Overtrading?

Where a business accumulates large amount of debtors, but not enough cash to pay suppliers. Also low cash = little or no dividends to shareholders.