Key to making money with shares. Lesson 17. Operating Cash Flow Margin. Google

If you understand a company’s cash flow, you can understand its financial standing. Without any adequate cash flow analysis, you can’t make any wise investments, let alone growing your investment portfolio.

1. Operating cash flow margin—also known as cash flow margin or margin ratio—is a commonly used profitability ratio that helps measure operating cash flow as a percentage of sales revenue. In simple terms, it shows how well a company converts sales into cash. Like operating margin, it’s a trusted metric of a company’s earnings quality.

2. Operating cash flow margin differs from the net margin, as the latter involves some operations that aren’t related to actual cash transactions. Amortization is seen as a go-to example of non-cash expenses that are recorded in the income statement but aren’t given in OCF.

Calculation Formula

Operating Cash Flow Margin = Cash Flow from Operations / Sales

Backed by reports, you can easily analyze the operating cash flow margin. All you need is to divide the total cash flow from operating activities by the net sales over a given period:

Operating Cash Flow Margin = Cash Flow from Operations / Net Sales

NOTE:

Don’t get things mixed up! The operating cash flow (OCF) is used in operating cash flow margin formula, whereas operating income is used to calculate the operating margin.

Formula elements:

Operating cash flow margin. Recorded in the cash flow statement, it’s a calculation that represents the revenue after operating costs have been deducted, i.e., cash being generated in the ordinary course of business. It shows whether enough funds are flowing into a company to cover any operating expenses. In case of a high OCF, a company can be considered to be financially viable in the long run. Also, OCF can prove that a company is forced to use external financing to expand its capital.
Net sales (revenue). We can look it up in the profit and loss statement. In the first line, we have gross sales, i.e., gross margin generated by a company. To calculate revenue, we need to subtract sales returns and allowances from gross margin.

Real-world example. Google

Let’s calculate the OCF margin and compare it with the previously learned FCF margin.

1. We are going to calculate the operating cash flow margin for the accounting period:

OCF Margin 2019 = $54,520 / $161,857 * 100 = 33.68%

OCF Margin 2018 = $47,971 / $136,819 * 100 = 35.06% OCF Margin 2017 = $37,091 / $110,855 * 100 = 33.46%

2. For further analysis, we need to take a look at the key difference between OCF and FCF:

OCF is cash generated by a company;
FCF is cash generated by business after deduction of capital expenditures (CapEx).

3. Let’s refer to Lesson 16 and calculate free cash flow margin for the accounting period:

FCF Margin 2019 = $30,972 / $161,857 * 100 = 19.13 %

FCF Margin 2018 = $22,832 / $136,819 * 100 = 16.69%

FCF Margin 2017 = $23,907 / $110,855 * 100 = 21.57%

4. Now we need to analyze the charts and data.

Google has demonstrated a steadily growing OCF over the past five years. What we see is that capital expenditures are the key difference between the two cash flow metrics as well as the FCF margin and OCF margin. This is why any changes in capital expenditures relative to income impact the ratio. Although the OCF margin grew in 2018, the FCF margin decreased due to capital expenditures that increased slightly.

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Standard

We have no one-size-fits-all ratio for every company due to significant differences between industries but some higher OCF margin is generally a better metric.
If the ratio rises over time, a company grows stronger by converting sales profit into actual cash flow in a more efficient way.
Savvy investors check historical margins, as they offer a bigger picture of profitability. If you notice some sales revenue growth without a related increase in cash flow, you need to figure it out. Ideally, the OCF margin should grow over time.
As working capital is an element of operating cash flow, investors should keep in mind that companies can impact their operating cash flow margin by deferring bill payments (saving their cash), cutting the time to receive payments (accelerating the receipt of money) and postponing the acquisition of material assets (saving their cash again).

Let’s sum things up

1. Why is cash flow, in particular OCF, valuable? It allows a company to roll out new products, grow, distribute dividends, buy back shares and cut back on commitments. Revenue, overhead costs and efficiency are major drivers of cash flow, while trends in negative operating cash flow margins are extremely illustrative.

2. Without positive cash flow, any company may be raising additional capital or slowing down its operations. However, it stands to mention that a negative operating cash flow margin value for some time isn’t always a bad sign, e.g., a company is building additional facilities with an eye to its future payback).

3. Traders use FCF and OCF as benchmarks when comparing similar companies in a given industry. It’s always essential to consider profit as well as operating and free cash flows when you analyze the companies you may potentially invest in. You obviously need to take a closer look at the profit, while cash flow based on actual transactions rather than projections will enable you to find out its quality.

⇐ Key to making money with shares. LESSON 16. Free cash flow margin as exemplified by Google Key to making money with shares. How to pick stocks ⇒

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