What Is the Operating Cash Flow Margin?
Let me explain what operating cash flow margin really is. It's a cash flow ratio that looks at cash from operating activities as a percentage of total sales revenue over a specific period.
Just like operating margin, you can trust this metric to gauge a company's profitability, efficiency, and the quality of its earnings.
Key Takeaways
- The operating cash flow margin reveals how effectively a company converts sales to cash and is a good indicator of earnings quality.
- Operating cash flow margin is calculated by dividing operating cash flow by revenue.
- This ratio uses operating cash flow, which adds back non-cash expenses.
- This is what distinguishes it from operating margin, which uses operating income that excludes such expenses as depreciation.
Understanding the Operating Cash Flow Margin
You need to understand that operating cash flow margin measures how efficiently a company turns sales into cash. It's a solid indicator of earnings quality because it only counts transactions involving actual money transfers.
Since cash flow comes from revenues, overhead, and operating efficiency, it tells you a lot, especially when you're comparing a company to its industry competitors. Ask yourself: Has operating cash flow gone negative because the company is investing to boost profitability? Or does it need outside capital just to keep going in a bid to turn things around?
Companies can improve this margin by using working capital more efficiently, but they might also temporarily boost it by delaying accounts payable, pushing for customer payments, or reducing inventory. If you see the operating cash flow margin rising year after year, it means free cash flow is improving, along with the company's ability to expand assets and create long-term shareholder value.
Another metric to consider is the Berry ratio, which compares operating expenses to gross profit. It helps cut through noise when comparing companies in different states with varying tax rates.
Operating Cash Flow Margin vs. Operating Margin
Let me clarify how operating cash flow margin differs from operating margin. Operating margin includes depreciation and amortization expenses, but operating cash flow margin adds those non-cash expenses back in.
You calculate operating margin as operating income divided by revenue. It's similar to operating cash flow margin, but it uses operating income instead. Operating cash flow margin sticks to operating cash flow, not income.
There's also free cash flow margin, which includes capital expenditures. In capital-intensive industries with high fixed-to-variable cost ratios, a small sales increase can lead to a big jump in operating cash flows due to operational leverage.
Operating Cash Flow Margin Example
Here's the formula you use: Operating Cash Flow = Net Income + Non-cash Expenses (Depreciation and Amortization) + Change in Working Capital.
Take company ABC's 2018 data: Sales = $5,000,000, Depreciation = $100,000, Amortization = $125,000, Other Non-cash Expenses = $45,000, Working Capital = $1,000,000, Net Income = $2,000,000.
For 2019: Sales = $5,300,000, Depreciation = $110,000, Amortization = $130,000, Other Non-cash Expenses = $55,000, Working Capital = $1,300,000, Net Income = $2,100,000.
Calculate 2019's cash flow from operating activities like this: $2,100,000 + ($110,000 + $130,000 + $55,000) + ($1,300,000 - $1,000,000) = $2,695,000.
Then, the operating cash flow margin is $2,695,000 / $5,300,000 = 50.8%.
Frequently Asked Questions
How does operating cash flow margin differ from operating margin? It includes non-cash charges like depreciation and amortization, highlighting a firm's ability to turn revenues into cash flows from operations.
What are cash flows from operations? Also called cash flows from operating activities or CFO, this is the money flowing through a company from its core business activities.
Is it better to have higher or lower operating cash flow margin? Higher is always better, as it means a greater proportion of revenues are becoming cash flows.
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