Operating cash flow

The operating cash flow is probably a better indicator of a company's profitability than the almighty earning because it shows how much money the company has in the bank (at the end of the reporting period) and if the bills can be paid with cash. It is computed by taking the net income and adding non-cash items that were subtracted (to the net income) and subtracting non-cash items that were added.

Depreciation and amortization (process of spreading out the cost of an asset over its useful lifetime) is a good example of expenses that show up completely differently whether you are looking at the income statement or the cash flow statement. Say, the company buys a piece of equipment for $5,000 cash and spreads out the expense over 5 years ($1,000 per year), the income statement will show a $1,000 expense every year whereas the cash flow statement will show the initial $5,000 expense in the first year (subtract $4,000 from income in the first year and add $1,000 afterwards).

The net income must be adjusted principally because of changes in the working capital (current assets minus current liabilities), in particular, inventories, accounts receivable and accounts payable. An inventory increase adds to the assets in the income statement. This increase is subtracted from the cash flow (since it does not generate any cash). Similarly, an inventory decrease subtracts from the assets in the income statement. This decrease is added to the cash flow (since it has generated cash). When a company sells a product that is not to be paid before the end of the reporting period, the selling price is added to the accounts receivable as asset in the income statement. In the cash flow statement, the selling price is deducted from the cash flow because cash has not actually been received for it. Similarly, when a company buys a product that is not to be paid before the end of the reporting period, the buying price is added to the accounts payable as liability in the income statement. In the cash flow statement, the buying price is added to the cash flow because cash has not actually been given. Regarding accounts receivable and payable, if goods were sold and bought with money changing hands within the reporting period, this difference between net income and operating cash flow would not exist.

Operating cash flow should be larger than the net income because depreciation and amortization reduce the income but not the cash flow. If it is not, then something is amiss and items like inventories, accounts receivable and payable should be looked at carefully since they may have been manipulated to bump the earnings.