Operating cash flow ratio
Operating cash flow ratio it is indicator used in the analysis of the company's financial liquidity.
It is one of the cash flow ratios which extent operational cash flows hedge the repayment of current liabilites. Describes short term liquidity.
If the company loses the ability to pay current liabilities, it will lose liquidity and will have problems with operating continuation. Traditionally information for financial about status of a business was contain from statement of income and statement of financial position. Statement of cash flow gived "supplementary information in undersanding the real operational status of a business ^{[1]}."
The formula is:
where:
- OCF - operating cash flow ratio
- CFfO - cash flow from operations
- CL - current liabilities
Cash flow from operations - include those receipts and expenses that are not classified as investing or financing activities.
Current liabilities - total trade payables and other payables that are payable within 12 months.
The operating cash flow ratio shows how many times current liabilities could be paid using cash flow. It should be greater than 1, but the higher the better. All cash flow ratios depending on the industry differ. They are not uniform, but an index smaller than one suggests financial problems of a given enterprise^{[2]}.
The loss risk of liquidity
Ability of a company to pay the short term liabilities (12 months ) measure liquidity. Better liquidity is a faster process of converting assets into cash. Liquidity can be measured using earnings, but those can be subject to manipulation. Therefore, cash flow can be more suitable. Cash flow ratio from operation it is important indicator when testing coverage of current liabilities them cash flow. Lack of liquid assets everytime causes shortages of funds to finance daily activity. When the enterprise can't of timely pay of current liabilities, Operating cash flow ratio be smaller than 1 ^{[3]}. Loss of liquidity's finance in the further period it will result in loss of profitability enterprise's.
Usage of operation cash flow ratio
Basic of financial analisis for stakeholders, whose want to know about the company's ability to continue its business in the future, is analysis is liquidity analisis ^{[4]}.
- Cash flow ratios prroviding information to creditors and suppliers
- Inwestors can testing the financial performance investment
- Menegers rate competitive positions of rivals
- Creditors, raiting agency and analittyc used cash flow ratio in analisis risk in investment
Cash flow ratios or traditional financial ratios
Traditional financial indicators based on information from the balance sheet usually examine only one specific moment. Thus, when the data to be analyzed comes from the moment when current liabilities have a low value compared to other periods, traditional financial indicators based on financial statements are not always able to demonstrate the existing problems of a given enterprise ^{[5]}.
However, in order to calculate the cash flow from operations, data on the value of cash flows from a given period are needed, as well as the calculation of the average value of current liabilities.
As recalled by R. Kajananthan and T. Velnampy (2014), more reliable data on the financial liquidity analysis can be found in the cash flow statement, however, it is not necessary to completely exclude traditional liquidity ratios. For example, in investment analysis both approaches should be used in order to have wider understanding of the company.
Cash flow ratio
In addition to the cash flow ratio from operations, there are also ^{[6]}:
- CFO/TL - Cash flow from operatons divided by total liabilities
- Cash flow interest coverage - Cash flow from operatons+ interest expenses divided by Interest expenses
- Cash flow margin - Cash flow from operatons divided by total revenue
- Cash flow to Net income - Cash flow from operatons divided by Net income
Examples of Operating cash flow ratio
- Operating Cash Flow Ratio: This ratio is used to measure a company’s ability to generate cash from its operations. It is calculated by dividing the operating cash flow (OCF) by the total current liabilities. For example, if a company has $100 in operating cash flow and $200 in total current liabilities, its operating cash flow ratio would be 0.5.
- Cash Flow to Debt Ratio: This ratio measures the company’s ability to pay off its debts with its operating cash flow. It is calculated by dividing the operating cash flow (OCF) by the total long-term debt of the company. For example, if a company has $100 in operating cash flow and $200 in total long-term debt, its cash flow to debt ratio would be 0.5.
- Cash Flow to Interest Coverage Ratio: This ratio measures the company’s ability to cover its interest payments with its operating cash flow. It is calculated by dividing the operating cash flow (OCF) by the total amount of interest payments. For example, if a company has $100 in operating cash flow and $200 in total interest payments, its cash flow to interest coverage ratio would be 0.5.
Advantages of Operating cash flow ratio
Operating cash flow ratio is an indicator used in the analysis of a company's financial liquidity. It is a useful tool for assessing the ability of a business to generate cash from its operations. The following are some of the advantages of using the operating cash flow ratio:
- It provides a reliable indicator of a company's liquidity position, allowing investors and creditors to assess the ability of a company to generate cash from its operations.
- It is a simple metric that can be calculated quickly and easily and does not require complex calculations or detailed financial analysis.
- It provides a measure of the company's ability to fund its operations, which is important for predicting future performance.
- It is a good tool for comparing a company's performance against other companies in the same industry.
- It provides a snapshot of the company's financial health and can be used to help identify potential problems with cash flow or liquidity.
Limitations of Operating cash flow ratio
The Operating Cash Flow Ratio is a useful tool for assessing a company's financial liquidity, however, it has certain limitations. These include:
- It can be difficult to accurately measure cash flow as it is not always easily tracked or reported.
- It does not take into account non-cash transactions, such as depreciation and amortization, which can have a significant impact on a company's financial performance.
- It does not account for the timing of cash flows, and so does not provide an indication of the company's ability to meet short-term obligations.
- It does not consider the company’s sources of financing, and so does not provide an indication of the company's overall liquidity.
- It does not provide an indication of the company's ability to generate future cash flows.
The Operating cash flow ratio is an indicator used in the analysis of a company's financial liquidity. Other approaches related to the Operating cash flow ratio include:
- Cash Flow Coverage Ratio - This ratio measures the ability of a company to cover its short-term debt obligations with the cash flow generated from its operating activities.
- Cash Flow from Investing Ratio - This ratio measures the amount of cash flow generated from investing activities, such as the sale of assets, investments, or acquisitions.
- Cash Flow from Financing Ratio - This ratio measures the amount of cash flow generated from financing activities, such as issuing debt or equity or repaying debt.
- Current Ratio - This ratio measures a company’s ability to meet its short-term obligations.
- Quick Ratio - This ratio measures a company’s ability to meet its short-term obligations without relying on inventory.
In conclusion, the Operating cash flow ratio is an important indicator of a company’s financial liquidity, but other ratios and approaches should also be considered when analyzing a company’s financial position.
Operating cash flow ratio — recommended articles |
Coverage ratio — Solvency ratios — Asset coverage ratio — Debt to total assets ratio — Fixed-Charge Coverage Ratio — Current portion of long-term debt — Capitalization ratios — Horizontal Analysis — Accounting ratios |
References
- Amah K. O., Ekwe M. C., Uzoma I. J. (2016). Relationship of cash flow ratios and financial performance of listed banks in emerging economies-nigeria example., European Journal of Accounting, Auditing and Finance Research, Vol.4, No. 4, p. 89-97
- Armen S., (2013). Performance assessment of major US airlines via cash flow ratios. Annals of the University of Oradea., Economic Science Series, 22(2), p. 398-408.
- Kajananthan R., Velnampy T. (2014). Liquidity, Solvency and Profitability Analysis Using Cash Flow Ratios and Traditional Ratios: The Telecommunication Sector in Sri Lanka., "Research Journal of Finance and Accounting", Vol.5, No. 23, p. 163-171
- Saleem Q., Rehman R. U., (2011). Impacts of liquidity ratios on profitability, "Interdisciplinary Journal of Research in Business", Vol.1, No 7, p. 95-98
Footnotes
Author: Justyna Banowska