How Should We Look at The Relationship Between Operating Cash Flows and Operating Earnings

Operating Cash Flows and Operating Income are two metrics that every serious investor should spend some time on when conducting investment analysis because they provide very useful information on recurring earnings and cash flows from the normal business operations.

Furthermore, the relationship between Operating Cash Flow (adjusted for non-recurring and non-operating items) and Operating Income is important because it can be indicative of a company's earnings quality and financial health. Usually those two metrics should move in same direction and any inconsistencies may suggest accounting problems. However, there may be valid reasons for the divergence of Operating Cash Flow and Operating Income. As I search for authoritative guidance on this topic, I found Chapter Eight of the book Creative Cash Flow Reporting by Charles Mulford and Eugene Comiskey extremely helpful.

Here are my summaries and notes:

"Reported operating cash flow can be much larger than operating income for capital intensive businesses. A capital intensive company need to invest heavily in Property, Plant and Equipment and these expenditures are included in the investing cash flows whereas the related depreciation is added back to operating cash flows. In addition, through the use of accelerated depreciation for tax purposes, deferred taxes liabilities are often recorded, which reduce net income, but not operating cash flow."

Notes: For capital intensive industries such as airlines and utilities, subtract capital expenditures from the reported operating cash flows to get "normalized operating cash flows." Even though GAAP classifies capital expenditures as investing cash flows, for capital intensive businesses, capital expenditures are in reality cash flows to maintain normal business operations and hence, operating in nature.

"Seasonal factors can also validate the temporary divergence between Operating Cash Flow and Operating Income. In anticipating stronger sales (such as holiday season), companies often build up inventory, which lead to lower Operating Cash Flow. As sales build later, earnings increase and inventory acquired earlier is liquidated. The net result is that operating cash flows can grow at a faster pace than operating income."

Notes: This is certainly true for retailers. Using Macy's as an example, here is the quarterly information for inventory, change in inventory and operating cash flows:

We can tell that there is a surge in inventory and a dramatic decline in operating cash flows in every third quarter and a decline in inventory and improvement in operating cash flow in every fourth quarter. The implication is that when we analyze quarterly financial information for retailers such as Macy's and JC Penney, we have to consider seasonal factors that are inherent to the business.

"An important but often ignored valid factor that drives the divergence between Operating Cash Flow and Operating Income is business cycle development, especially for those cyclical companies. As companies and industries go through cyclical changes, the relationship between earnings and operating cash flow also change. During a recession, a cyclical company will experience a decline in revenue and operating income. Net losses may ensue. However, the company may also reduce inventory accordingly, resulting in improvement in operating cash flow. As the recovery goes, cash flow may decline as inventory levels are brought up back to the pre-recession levels whereas earnings are improving. Gradually, as the business moves beyond the effects of business-cycle changes on its operations, more stable relationship between earnings and operating cash flows should return."

Notes: Again, let's use Macy's to illustrate this point. Below is selected Macy's financial information from 2006 to 2012:

Even though Macy's operating income and net income deteriorated materially from 2006 to 2009, the drop in operating cash flow was not as dramatic. However, this divergence between operating cash flow and operating income is expected and therefore, not to be interpreted as red flags.

"Investors also often misunderstand the effect of business life cycle has on the relationship between Operating Cash Flow and Operating Income. A company's earnings and operating cash flows have certain characteristic relationships that depend on the stage of the life cycle in which it operates."

Notes: Business cycle development is certainly a factor that is often obliterated by investors. Here is the summary of the earnings and cash flow characteristics of each phase in the cycle.

• Start up phase (2003-2004): A start up firm usually experiences net losses as it spends on SG&A and not generating enough revenues. It may consume even more operating cash flow as early sales result in increase in A/R and as inventories are accumulated. 

• Early Growth Phase (2005-2006): Revenue continues to grow and earnings may turn positive. However, continued increase in A/R and inventory may cause the company to report negative Operating Cash Flow. In the transition between start-up and growth, earnings often turn positive before Operating Cash Flow. 

• Established Growth Phase (2007-2012): As the company continues to grow, the growth rate of A/R and inventory should gradually lag the growth rate of earnings and Operating Cash Flow should turn positive. Moreover, as depreciation continues to grow, lowering operating income without lowering Operating Cash, Operating Cash Flow should eventually exceed Operating Income. A company may operate in the growth stage of its life cycle for an extended period. During that period, the stable relationship between Operating Cash Flow and Operating Income should persist. 

• Late Growth Phase and Maturity Phase: As revenue growth slows or even declines, the company may still report operating income. Restructuring events are likely to happen. However, when the company begins taking significant NON-CASH restructuring charges, the spread between Operating Cash Flow and Operating Income will increase. It would not be surprising to see the company continue generating positive Operating Cash Flow. Only if the company were to remain unprofitable and enter an extended period of decline would it run the risk of beginning to consume cash from operations. 

• Decline Phase: A company in decline may report losses but provide ample amounts of operating cash flow as investments in working capital accumulated during earlier periods of growth are liquidated. However, as the decline continues, positive cash flows will likely turn negative. 

After considering the above factors, if a company's Operating Cash Flow is not consistent with the Operating Income, its earnings quality may very well be questionable. At this point, the prudent investor should adjust the reported cash flows from operations for non-recurring and non-operating items and adjust operating earnings for non-recurring and non-operating items as well. If there is still a significant divergence between the adjusted Operating Cash Flow and Operating Income after considering all the above factors, the investor should further analyze the reason for the divergence, extrapolate the implications and proceed with caution.