Introduction
Prior to investing in a company, it is worth noting its level of profitability and the level of efficiency with which it operates. Analysts, in particular, often make use of a number of ratios and calculations in order to ascertain whether a company ought to be invested in or not. One of the tools that they happen to use is the operating cash flow margin. This article seeks to examine all that this metric entails and how it is calculated.
Defining Operating Cash Flow Margin
Operating cash flow margin can be classified as a cash flow ratio that is used to assess what the cash from operating activities amounts to in the form of a percentage of the total sales revenues for an outlined period of time. Much like operating margin, the OCF margin is a reliable tool that is used to assess how profitable a company is, its level of efficiency, and the quality of its earnings. It is able to adequately assess what the earnings quality of a company is as it only takes into account transactions that involve actual money being transferred.
Owing to the fact that cash flow is based on the operating efficiency, revenues, and overhead of a company, it can be a most reliable tool when analyzing a company. This holds particularly true with regard to comparisons drawn between competitors operating in the same industry. With this metric is possible to determine why a company is positioned the way it is. Questions pertaining to why the operating cash flow of a company is negative and reasons behind this such as owing to investments in operations aimed at making the company even more profitable are answered with this metric. It can also be used to make clear whether a company needs capital from external sources in order to buy more time such that it can continue to operate or whether this external capital will truly be able to transform the company into a profitable enterprise.
In the same manner that companies can enhance their operating cash flow margin by using their working capital in a more efficient way, they can also enhance their operating cash flow margin for a temporary period of time by postponing the payment of accounts payable, getting after customers to make their payments or by lowering their inventory. However, if a company’s operating cash flow margin continues to rise over the years, it indicates that the free cash flow (or FCF) of the company is improving. Moreover, it also makes clear that the company’s ability to broaden its asset base is improving along with its ability to generate long-term value for those who have invested in it i.e., its shareholders.
Operating Cash Flow Margin Set Against Operating Margin
It is important to understand that operating cash flow margin lies in contrast to operating margin. While operating margin takes into account depreciation along with amortization expenses, operating cash flow margin adds up non-cash expenses including depreciation.
In order to calculate the operating margin, you must divide a company’s operating income by its revenue. While the cash operating margin is calculated in a similar manner, the cash under consideration differs as this margin makes use of operating cash flow as opposed to operating income.
Another margin measure that is worth noting here is the free cash flow margin which also takes into account capital expenditures and adds them. Industries which employ ample sums of capital and have a high ratio of fixed to variable costs are capable of accruing vast increases to their operating cash flows with small increases in their sales. This is due to operational leverage.
Illustrating Operating Cash Flow Margin with an Example
The formula of the operating cash flow margin is as follows.
Operating Cash Flow = Net Income + Non-Cash Expenses (Depreciation and Amortisation) + Change in Working Capital
In order to better illustrate this formula, consider the following example.
Company XYZ recorded the following information to their ledger for their business activities in 2019.
Sales = INR 500,000
Depreciation = INR 10,000
Amortisation = INR 12,500
Other Non-Cash Expenses = INR 4,500
Working Capital = INR 100,000
Net Income = INR 200,000
They also happened to record the following business activities to their ledger in 2020.
Sales = INR 530,000
Depreciation = INR 11,000
Amortisation = INR 13,000
Other Non-Cash Expenses = INR 5,500
Working Capital = INR 130,000
Net Income = INR 210,000
The cash flow from operating activities for 2019 can therefore be calculated as follows.
Cash Flow from Operating Activities = INR 210,000 + (INR 11,000 + INR 13,000 + INR 5,500) + (INR 130,000 – INR 100,000) = INR 269,500
In order to determine what the operating cash flow margin is from this number, it must be divided by sales.
Therefore, Operating Cash Flow Margin = INR 269,500 / INR 530,000 = 50.84 %.
Final Thoughts
Cash flows drawn from operations are available under a company’s statement of cash flows. In case they aren’t made apparent here, they can be calculated manually. This margin makes clear the amount of money a company earns from its operations and accounts for a portion of the company’s net sales for a given time frame. Companies and investors alike use this metric to determine the efficiency with which a company creates operating cash via its revenue. In the event that a company has a negative cash flow margin, it indicates that the company is losing money as opposed to making a profit.
