Are you looking for a way to measure your company’s cash flow, debt, or liquidity ratio?
Are impending product launches, major expenses, or expansion plans not letting you sleep at night?
Then you must get an idea of the company’s operating cash flow ratio to have a clear picture of its earnings.
Operating cash flow ratio helps you measure a company’s liquidity by determining how capable it is to cover liabilities by the money it is making from its primary operations. It has a few aspects and a formula for accurate calculation.
We have for you a complete guide of all operating cash flow ratio questions and aspects that you will need. Read on to learn more about operating cash flow ratio, its formula, and examples. The topics we will cover are:
- Operating Cash Flow Ratio
- Uses of Operating Cash Flow Ratio
- Operating Cash Flow Ratio Formula
- Operating Cash Flow Ratio Components
- Examples of Operating Cash Flow Ratio
- Operating Cash Flow Ratio vs. Current Ratio
- Limitations of Operating Cash Flow Ratio
Operating Cash Flow Ratio
Operating cash flow is a liquidity ratio that determines the capability of a company to cover its liabilities with the cash flow from core operations. Basically, it measures how much a company or firm is earning through its operating activities compared to each unit of liabilities.
To get the correct operating cash flow ratio, you must find out the exact cash flow that the company’s primary business operations are generating. Then, you must determine how much the current liability is. Both these figures can be found in the cash flow statement or balance sheets.
The operating cash flow ratio measures a company’s short-term liquidity by using cash flow as opposed to net income. This is considered a better and more accurate way to measure this aspect as earnings can be more easily manipulated than liabilities in the operating cash flow ratio.
- Operating cash flow ratio indicates whether the company is capable of covering its short-term obligations through its normal business operations
- Cash flow from operations (CFO) is preferable over net income to calculate the operating cash flow ratio as it is a more trustworthy figure that is tough to manipulate
- A higher operating cash flow ratio is better as it means the company has generated a high amount of cash in a particular time period
Uses of Operating Cash Flow Ratio
Operating cash flow ratio is considered an important liquidity measure for a company as it gives a clear idea of the money being generated. It should be considered along with other liquidity and financial ratios like quick ratio, cash ratio, and current ratio.
There are several uses of operating cash flow ratio in determining the financial health of the company
- It measures the ability of a firm to pay off its immediate debts
- It gauges the earnings that a company has generated through its functions
- It helps investors and business analysts to compare competitive businesses with similar operations
- It is subject to less manipulation and accounting errors as it takes actual cash flow figures into account
- It helps companies to plan activities like expansions, product launches, dividend payments, debt clearance, and so on
- It allows the company to remain flexible and on top of expenses
- It prevents a company from going into massive debt or becoming bankrupt
Operating Cash Flow Ratio Formula
The operating cash flow ratio is calculated by dividing the cash flow coming from core operations by the number of liabilities that the company currently has. It determines the number of times the current liabilities can be paid from the net operating cash flow.
This formula also helps to keep a check on the net profit and profit margin by tracking the operational cash flow of the company. The operating cash flow ratio (OCF ratio) formula can be written as:
OCF Ratio = Cash flow from core operations / Current liabilities
In this equation, cash flow includes figures such as revenue accrued through operations plus the non-cash-oriented revenue. Whereas the current liabilities include debts, short-term loans, creditors, accrued expenses, and the like.
You will find these figures in company balance sheets and cash flow statements. In case that information is not available, you can determine cash flow by taking the net income, adding non-cash expenses like depreciation, subtracting non-cash gains like sales of assets, and then factoring in any increase in current liabilities or decrease in current assets and decrease in current liabilities or increase in current assets.
If the operating cash flow ratio is greater than one, it denotes that the company has more than enough liquid net worth to pay off its liabilities. The higher the number, the better shape the company is in.
On the other hand, if the operating cash flow ratio is lower than one, it means the company needs more capital to remain afloat after paying off short-term dues. However, a low number maybe for other reasons as well, such as temporary expenditure in product launches or expansions, etc.
Operating Cash Flow Ratio Components
The operating cash flow ratio has various components attached to it. It gives you an idea of the company’s cash flow situation, profit and loss margins, and ability to survive financial hits.
Before you look at the operating cash flow ratio, you must understand a few concepts. A company generates revenue from its operations, but the actual cash flow can be determined by deducting the cost of goods sold (COGS) and other associated expenses.
These expenses can be anything, such as attorney fees, office space rent, utilities, maintenance, etc. Current liabilities, on the other hand, are all liabilities within one fiscal year or operating cycle. The cash flow from operations is equivalent to net income, after all these deductions.
Investors tend to look at the cash flow over net income before deciding to invest in a company. They have to determine whether the company is in profits or even eligible to break even, before they put money in.
Examples of Operating Cash Flow Ratio
Let us take a few examples into account to learn more about the operating cash flow ratio.
1. First, we consider a company; let’s name it Bower Technologies. Now, we will compute the liquidity of Bower Tech using the operating cash flow ratio formula.
|
Area |
Amount ((US$) million) |
|
Current Liabilities |
9.75 |
|
Cash Flow from Operating Activities |
8.72 |
Hence, with the operating cash flow ratio formula:
OCR Ratio = Cash flow from operating activities / Current liabilities
= 8.72 / 9.75
=0.89
Since the ratio is lower than 1, it indicates that Bower Technologies has a weak financial standing or is incapable of paying off short-term liabilities at this point.
2. Now, let us consider another example. This time, we will calculate the operating cash flow ratio of a fictional company, Enigma Travels.
|
Area |
Amount ((US$) million) |
|
Current Liabilities |
6.75 |
|
Cash Flow from Operating Activities |
11.72 |
Therefore, the operating cash flow ratio of Enigma Travels is:
OCF Ratio = 11.72 / 6.75
= 1.73
This means that the company can cover its current liabilities 1.73x times over. Hence, Enigma Travels can be considered to be in good financial standing.
3. If we look at real-world examples, two retail giants Walmart and Target had current liabilities of $77.5 billion and $17.6 billion respectively, in February 2019. In the next 12 months, Walmart generated $27.8 billion in operating cash flow, whereas Target generated $6 billion.
Thus, the operating cash flow ratio for Walmart is 0.36, whereas Target’s is 0.34. Since these figures are so close, we can say that Walmart and Target have similar liquidity. They also share similar current ratios, even though their liabilities and operating cash flow amounts are very different.
Operating Cash Flow Ratio vs. Current Ratio
Both the operating cash flow ratio and current ratio help in measuring a company’s short-term liabilities and debts. The only difference is that the operating cash flow ratio takes into account the cash flow from operations, whereas the current ratio considers the current assets.
So basically, the operating cash flow ratio assumes that the current liabilities will be paid off with the cash that the company has earned from its operations and activities. On the other hand, the current ratio assumes that the company will use its current assets to pay the liabilities or debts off.
|
Operating Cash Flow Ratio |
Current Ratio |
|
It is a financial metric that determines the short-term liquidity of a business. |
It is a liquidity ratio that determines a company’s ability to pay its debts. |
|
It measures a company’s ability to pay off short-term liabilities. |
It measures a company’s ability to pay off immediate liabilities. |
|
It takes cash generated from operations into consideration. |
It takes the company’s current assets into consideration. |
|
Its formula is: OCF Ratio = Cash flow from core operations / Current liabilities |
Its formula is: Current ratio = Current assets / Current liabilities |
Limitations of Operating Cash Flow Ratio
Although there are several advantages of calculating the operating cash flow ratio, it does have some limitations.
- It should be used along with other financial ratios for proper analysis
- The operating cash flow ratio can be manipulated, although it is not as easy to do that as with other numbers
- A low OCF ratio does not always indicate a poor financial situation. It may be a result of other expenditure activities. Hence, investors cannot get the complete picture for this
- The depreciation expenses must be added back in cash flow operations to get the correct operating cash flow ratio, which some companies fail to do
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Conclusion
The operating cash flow ratio is an important financial metric that comes in handy, both for business owners and potential investors. For best insights, it should be used in conjunction with other financial ratios for a holistic analysis of a company’s financial health. In general, any company that can consistently maintain an operating cash flow ratio greater than 1, is considered to be doing well.
Key Takeaways
The operating cash flow ratio lets you measure a company’s liquidity by determining how capable it is to pay off debts or liabilities in the short term by the money it makes from core business operations. It is useful to determine a company’s cash flow and debt accountability.
- It considers the cash flow from operations for the calculation, as opposed to net income. This is because this figure cannot be easily manipulated
- An operating cash flow ratio higher than 1 denotes that the company is sufficiently capable of paying off short-term debts and liabilities. Any figure less than 1 indicates a poor financial standing
- However, this number can be lower due to various other factors, like business expansions, product launches, major marketing efforts, etc. So, it is not an accurate representation of the company’s financial health
- The OCF ratio helps companies plan activities like expansions, product launches, dividend payments, debt clearance, and so on. It also helps to compare performance with competitors to gain potential investors
- Calculating the OCF ratio helps companies to remain financially flexible and prevents them from going into debt or bankruptcy
- The operating cash flow ratio (OCF ratio) formula can be written as: OCF Ratio = Cash flow from core operations / Current liabilities
- The components of OCF ratio are the cost of goods sold, revenue from key operations, associated expenses, and current liabilities
- The operating cash flow ratio can be compared to the current ratio. The only difference between calculating the two is that the OCF ratio considers the cash flow from operations whereas the current ratio considers the current assets.
- The limitation of the operating cash flow ratio is that it must be considered along with other financial ratios for an accurate interpretation
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