Operating cash flow and profit

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Sometimes the simplest analytical ratios are the best. They are easy to remember, easy to calculate and they provide a capsule of vital information.

One of these is simply to divide operating cash flow by operating profit. The two numbers are easily found, respectively in a company's cash flow statement and in the profit and loss account. To compare like with like, operating cash flow should be a number struck before deducting tax, interest and dividends, since none of these features in the operating profit number.

The simple rule of thumb is that the resulting ratio should always be greater than one. In short, operating cash flow should always exceed operating profit.

To understand why, we need to look at the structure of the profit and loss account. Operating profit is almost always calculated after deducting items like depreciation, amortisation and sometimes some other items that either flatter or diminish profits, but that do not actually involve a movement of cash. That's to say, no payment or receipt is involved.

In accounting parlance these are 'book entries'. Other book entries might include profits on sales of assets or retained profits of partly-owned companies.

Because they involve no movement in cash, they are added back to operating profit to arrive at operating cash flow. Because depreciation and amortisation are very often much larger than any other book entries, it should almost always be the case that operating cash flow is a higher number than operating profit.

If this turns out not to be the case, what then?

The reason for such an outturn is most often found in working capital. Working capital is the net balance of stocks, debtors (money due to be received), and creditors (money due to be paid).

Look in the notes to any set of accounts and you will find a table that reconciles operating profit to operating cash flow. Included in the table, as well as the book entries already mentioned, will be a note of changes to stocks, debtors and creditors. The balance of these items often provides the answer as to why and by how much a company's operating profits differs from cash flow, or specifically why profits may continue to rise without their being a corresponding increase in cash flow. Profits can continue to rise if working capital ratios take the strain.

But in circumstances like this, profits are illusory, because flexing working capital ratios - by chasing customers to pay more quickly, or making suppliers wait for their bills to be paid - is only a short-term palliative.

When companies try to do it, this simple ratio highlights what is taking place.

Peter says

The beauty of the ratio is that what it is really showing is the efficiency with which profits are converted into cash, which is the lifeblood of any business. An additional benefit is that it speaks volumes about the integrity of the company and the fundamental conservatism and rectitude of its accounting.

Companies that have cash conversion ratios of appreciably less than 100% are on a slippery slope, because they are generating less cash than their income statement implies. Conversely, the more the ratio exceeds 100%, the more profits are being 'hidden' (perhaps by a very conservative depreciation policy).

In both cases, the truth will come out eventually.

An unduly lax company will head for the corporate knackers' yard, while an unduly conservative firm may find itself revamped by new management, by a bidder, by a change of effective control, or by some other catalyst. Companies that are tightly held by a family group can be, for example, among the most conservative. Value is often released in situations like this when family shareholdings become too widely diffused for unduly conservative accounting to persist.

Be that as it may, the ratio reveals all. It works for all types of non-financial companies. It is also good to compare the operating cash flow to operating profit ratio over a period of years, to make sure that the figures are consistent and not simply showing an unsustainable one-off improvement.