Papers: Developing a Greater Understanding of the Relationship between Operating Cash Flow and Net Income

Understanding the intrinsic relationship between operating cash-flow and net-income may provide important insight into the performance and economic well being of the firm. Expansion in working capital account balances that place downward pressure on operating cash flow will often precede increases in net income. In contrast, increases in operating cash flow will oftentimes provide a false sense of security to company managers that are flush with cash as net working capital requirements decline. Most financial managers keenly follow both measures separately. However, this paper will demonstrate that the relationship and timing between the two measures may provide the most meaningful insight of all.

Individual companies exhibit substantial differences with respect to operating cash to net income. Steady, but not overwhelming pressure on operational cash flow compared to net income normally indicates a healthy, growing company. To be sure, astute financial managers that understand the proper tension between operating cash flow and net income are better equipped to respond to signals that foretell the story that lie ahead.

A review of the academic paper titled, “Information Provided by Accrual and Cash-Flow Measures of Operating Activities” by Ingram and Lee, (1997) is used as the backdrop for this paper and provides substantial evidence and support for the use of operating cash-flow to net-income as a management tool. Accordingly, this paper will draw heavily from the article and will therefore acknowledge the author’s important contribution to this subject.