| Continuing our discussion on cash flow 101, I | | | | loss. Furthermore, interest expense is deemed |
| feel that cash flow discussion is not | | | | to vary depending on a firm's capital |
| complete without digging further into | | | | structure. A firm may pay more or less |
| operating cash flow. To refresh your memory, | | | | interest expense due to the amount of debt it |
| operating cash flow is the cash flow | | | | holds, not due to its operating efficiencies. |
| generated by a firm's business activities. | | | | Finally, depreciation and amortization is the |
| Business exists to produce cash flow. | | | | subtraction of long term asset purchased |
| Therefore, we prefer business that spots a | | | | outside of the accounting period. Therefore, |
| positive cash flow. | | | | no cash actually flows out of the coffer |
| | | | during the period. |
| We do invest in companies that produce | | | | |
| negative cash flow in certain ocassions. For | | | | Let's take a look at a typical cash flow |
| example, this is the company that is growing | | | | statement for Merck & Co Inc. (MRK). For the |
| rapidly and in order to create barrier of | | | | fiscal year ending on December 2006, Merck |
| entry, the company is investing heavily while | | | | reported net income of $ 4.34 Billion. |
| business hasn't picked up. An example of this | | | | Operating cash flow meanwhile, was reported |
| scenario is: biotech companies that spend | | | | at $ 6.77 Billion, mainly due to $ 2.27 |
| money on Research & Development or retailers | | | | Billion addition of depreciation. There is |
| giving away free shipping to gain customer | | | | also adjustments due to change in liabilities |
| loyalty. | | | | and/or inventories as well as account |
| | | | receivables. That is a given. When you do X |
| There is also a little thin line of | | | | amount of sales but you did not get cash back |
| classifying expense of between operating cash | | | | (a.k.a bulging account receivables), your |
| flow and say investing cash flow. A retailer | | | | operating cash flow would be affected. There |
| that is giving away free shipping might | | | | is also a line called 'Adjustments to Net |
| experience a positive operating cash flow but | | | | Income', which is not clear from the example |
| negative investing cash flow if it feels that | | | | above. For the most cases, however, cash flow |
| the free shipping is a long term investment | | | | generated from operation is a higher figure |
| to create barriers of entry. However, for the | | | | than the net income figure. |
| most part, that kind of expense will fall | | | | |
| into operating cash flow since it relates to | | | | Now, how would cash flow from operations help |
| the daily part of the company's business. | | | | us in investing in stocks? In the absent of |
| | | | dependable cash flow from operations, we |
| Now, what constitutes a positive cash flow | | | | prefer to invest in companies that have |
| from operations? Generally, we work our way | | | | positive net cash on their balance sheet. |
| back from the income statement. From the net | | | | This means more cash on hand than it has |
| income, we have to add depreciation and | | | | debt. If a firm has dependable huge cash flow |
| amortization, interest expense and taxes. | | | | from operations, it can compensate for the |
| This is because, theoretically, a firm is not | | | | lack of strength in its balance sheet (i.e: |
| required to pay taxes if it reported a net | | | | less cash than long term debt). |