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Cash Flow Ratios

Understand the cash generation & utilization by companies with these ratios. Get an insight into how companies manage their cash flows.

Gopal Kavalireddi
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The difference between the cash income and cash expenditure is termed as Cash Flow. An acute measure of liquidity management, the cash flows highlighted in the cash flow statement helps in understanding the inflow and outflow of cash in the business. Cash flows are categorized based on their activities, namely, cash flow from operating activities, cash flow from investing activities and finally, cash flow from financing activities. A higher level of cash flow indicates a better ability to weather the declines in the operating performance and to pay dividends to investors.

Cash flow is the sum of profit, depreciation, and changes in the long term reserves of the company. As cash is critical, it is imperative that investors consider the cash flow ratios to determine the liquidity & solvency of the company’s business. Some of the widely used cash flow ratios are operating cash flow to sales ratio, free cash flow to operating cash ratio, cash flow coverage ratio, cash flow per share, cash flow liquidity, and other ratios based on usage of cash flows instead of the accounting profit.

 

Operating Cash Flow (OCF)

The cash generated from the core operations of a business is termed as Operating Cash Flow. Operating cash flow is useful for the investors in understanding the performance of the normal operations of the company. Generally accepted accounting principles require public companies to calculate operating cash flow using the indirect method by adjusting net income to cash basis, using changes in non-cash accounts, such as depreciation, accounts receivable and changes in inventory.

Operating cash flow is calculated as:

OCF = Operating Income + Depreciation – Taxes ± Change in Working Capital for the period

Where

  • Operating Income = Revenue – COGS and

  • Change in Working Capital = (Previous Current Assets – New Current Assets) + (New Current Liabilities – Previous Current Liabilities)

Since OCF determines the company’s ability to generate sufficient positive cash flow required to maintain and grow its operations, the higher it is, the better.

 

Free Cash Flow (FCF)

An efficiency and liquidity ratio measuring the additional cash generated from the operating activities of the company, net of capital expenditures is termed as Free Cash Flow. Simply put, it is the excess money available for a business after accounting for operating expenses (OPEX) and capital expenses (CAPEX).

Free Cash Flow is calculated as:

FCF = Operating Cash Flow - Capital Expenditure

Free cash flow is important as it highlights the business efficiency of the company in generating excess cash and providing dividends to investors, even after funding is organic and inorganic growth. A positive FCF is always better and preferred, while negative FCF might imply that the business is investing heavily in new equipment and other capital assets causing the excess cash to wane.

 

Operating Cash Flow to Sales Ratio

The amount of cash generated from operating activities for every unit of sales is defined by the Operating Cash Flow Ratio. Also referred to as Cash Flow Margin ratio, it is the cash flow from regular business operations divided by sales. 

Operating cash flow to sales ratio is calculated as:

Operating cash flow to Sales Ratio = Cash flow from Operating Activities / Net Sales

A high operating cash flow margin can indicate that a company is efficient at converting sales to cash, and may also be an indication of highly qualitative earnings. This is a comparatively reliable metric than net profit, as it depicts a clearer view of the amount of cash generated per unit of net sales.

By implementing strategies to strengthen the operating cash flow margin, a company can rely more on internally generated cash flows rather than debt for funding, to support its operations. The greater the amount of operating cash flow, the better.

 

Free Cash Flow to Operating Cash (FCF/OCF) Ratio

The ratio indicating the relationship between the free cash flow and operating cash flow is the Free Cash Flow to Operating Cash Flow ratio.

Free Cash Flow to Operating Cash Flow Ratio is calculated as:

FCF/OCF Ratio = Free Cash Flows / Operating Cash Flows, or

FCF/OCF Ratio = (Operating Cash Flow – Capital Expenditures) / Operating Cash Flow

This ratio indicates the amount of free cash flow generated for every unit of operating cash flow. A higher ratio is preferable and is a very good indicator of financial health of a company. But at the same time, a higher ratio indicates that the company is not investing much on expanding the assets and therefore, is seeking sustainable operations rather than opting for higher growth.

 

Cash Flow Coverage (CFC) Ratio

An indicator of the liquidity position and the creditworthiness of a company, the Cash Flow Coverage Ratio measures the ability of the company to meet its financial obligations as per requirement. This ratio indicates the number of times the financial obligations of a company are covered by its earnings. Hence a greater operating cash flow is very necessary and helps in improving the coverage position. This ratio is also called the cash flow to debt ratio.

Cash Flow Coverage Ratio is calculated as:

CFC Ratio = Operating Cash Flows / Total Debt

A CFC ratio greater than or equal to 1 implies that the company is in good financial health and can meet its financial obligations via the cash generated by operating activities. Alternately, a ratio of less than 1 indicates poor health and a continuously lower trending ratio increases the chances of the bankruptcy of the company.

Additional ratios are derived from this basic ratio to indicate coverage as: short term debt coverage ratio, capital expenditure coverage ratio, and dividend coverage ratio etc. where the numerator is operating cash flows and the denominator is short term debt, capital expenditure and dividends.

 

Cash Flow per Share Ratio

A financial ratio that measures the operating cash flow ascribed to each common share is termed as Cash Flow per Share ratio. Cash flow per share indicates the amount of cash generated for every share of the company.

Cash Flow per Share ratio is calculated as:

CFPS = (Operating Cash Flow – Preferred Dividends) / Avg. of Total Shares Outstanding

Since the cash flow per share takes into consideration a company's ability to generate cash, it is regarded as a more accurate and reliable measure of a company's financial situation in comparison to the earnings per share.

 

Cash Flow Liquidity Ratio

A ratio comparing the cash and cash equivalents, marketable securities, and cash flow from operating activities to the total current liabilities of the company is termed as the Cash Flow Liquidity ratio. This ratio measures the ability of a company to meet its short term debt with its cash and other liquid assets.

Cash Flow Liquidity ratio is calculated as:

CFL = (Cash and Cash Equivalents + Marketable Securities + Operating Cash Flow) / Total Liabilities

A consistently increasing cash flow liquidity ratio is preferred for any company.

 

Dividend Payout Ratio

A ratio indicating the ratio of the dividend paid to the net profits of the company is termed as the Dividend Payout ratio.

Dividend Payout Ratio is calculated as:

Dividend Payout Ratio = Total Dividends / Net Profit, or

Dividend Payout Ratio = Dividends per Share / Earnings per Share

A portion of the company’s net profits are used to pay the dividend and the balance is retained for further growth of the company. Hence, investors concerned about short term earnings prefer to invest in companies with a high dividend payout ratio. On the other hand, investors who prefer to have capital growth like to invest in companies with lower dividend payout ratio.

Companies with large and stable businesses usually have a higher dividend payout ratio, while new and high growth businesses have lower or unflattering dividend payout ratio. The dividend payout ratio should not be too high or consistently increasing, as it is not considered healthy and indicates the company inability to cover its dividend payout from the net profits.

 

Cash Flow Return on Investment (CFRoI)

A valuation metric analyzing the company’s cash flow to the capital employed is Cash Flow Return on Investment. This ratio is used by investors who opine that cash flow is the underlying driver of the value in a company, as opposed to earnings or sales.

Cash Flow Return on Investment is calculated as:

CFRoI = Operating Cash Flow / Capital Employed

Where,

  • Capital employed is the company’s total assets after deducting its current liabilities.

It is most informative when compared to WACC, as it allows investors to see the divergence between the amount paid by the company to raise funds, vis-à-vis, the amount of return a company receives by investing those funds.

 

Cash Return on Gross Investment (CRoGI)

For capturing the total value of investment in the asset base more accurately, another ratio that is used by analysts is the Cash Return on Gross Investment. It is the ratio obtained by dividing the operating cash flow after tax by gross investment.

Cash Return on Gross Investment is calculated as:

CRoGI = Operating After Tax Cash Flow / Gross Investment

Where,

  • Operating after-tax cash flow = Net Operating Profit after tax + depreciation + Other non-cash items, and

  • Gross Investment = Invested Capital + Accumulated Depreciation + Capitalized Expenses

Another indicator of the rate of return, this ratio is used to understand the efficiency of the capital used for purchases or in simple terms, to identify a company's ability to generate cash returns on its investments. This financial parameter was originally developed by HOLT Value Associates in 2002 and is an economic profit based valuation framework used by portfolio managers.

 

Next Chapter

Valuation Ratios

7 Lessons

Learn the process of determining a company's worth using different valuation ratios and the implications of using the ratios.

Altman Z Score Financial Models

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It's a combination of ratios which helps to understand a company's health, creditworthiness and the likelihood of it's bankruptcy.

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