NEGATIVE OPERATING CASH FLOW = SIGN OF TROUBLE?

Is a negative operating cash flow (OCF) a sign of trouble?

Most finance textbooks will highlight companies with a negative OCF as companies having some difficulties in their operations.

In practice, it does not have to be the case, because there are rarely black-and-white cases.

There are many companies out there with negative OCF and high creditworthiness.

But there are some preconditions which have to be met.

1) Negative OCF has to be a temporary situation

Prolonged negative OCF means that a company needs to cover the minus coming from OCF. It can be through issuing bonds, taking new loans, issuing equity, selling assets… Whatever the source of cash to cover the gap, longer periods of negative OCF are probably a sign of issues.

Unless…

2) High growth has to be healthy

…the company is growing very quickly. In that case, negative OCF is a rather common situation.

Still, growth has to be healthy, otherwise it can all go wrong.

What does it mean that growth is healthy?

Normally, negative OCF stems from investments in working capital (inventories, trade receivables, trade payables).

Healthy investments in working capital mean:

• purchasing inventories of a good quality, which can easily be sold at a market price in case of need
• generating higher receivables from creditworthy customers and at reasonable payment terms, meaning these receivables can be sold close to face value in case of need
• paying suppliers early in a sustainable way, meaning the benefits of early payments have to outweigh the negatives of paying early

Healthy working capital management is the key to healthy growth.

3) Leverage has to be low

A highly leveraged company will likely have issues in case of negative OCF, because it has to find new sources of money to cover the gap.

But who will lend the money at favourable terms if a company is highly leveraged?

Financing the gap in OCF with double-digit interest rates normally does not make much sense.

4) Strong business model

Companies which are leaders in their industries will normally survive periods of negative OCF easier than small companies with a risky business model and a volatile cash flow because larger companies with strong market position will finance the OCF gap much easier.

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To sum up, next time you see a negative OCF in a company’s cash flow statement, ask yourself these questions:

1. Is it a temporary situation?
2. Is the company’s growth healthy?
3. Is the company’s leverage level low enough?
4. Is the company’s business model strong enough?

Then you’ll have it easy figuring out whether the negative OCF is a sign of trouble or not.

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