Operating Cash Flow Ratio
What Is the Operating Cash Flow Ratio?
The operating cash flow ratio is a measure of how promptly current liabilities are covered by the cash flows created from a company's operations. This ratio can assist with measuring a company's liquidity in the short term.
Involving cash flow instead of net income is viewed as a cleaner or more accurate measure since earnings are all the more effortlessly controlled.
The Formula for the Operating Cash Flow Ratio
The operating cash flow ratio is calculated by partitioning operating cash flow by current liabilities. Operating cash flow is the cash produced by a company's normal business operations.
Operating Cash Flow Ratio Components
A company produces revenues — and deducts the cost of goods sold (COGS) and other associated operating expenses, for example, attorney fees and utilities, from those revenues. Cash flow from operations is the cash equivalent of net income. It is the cash flow in the wake of operating expenses have been deducted and before the beginning of new investments or financing activities.
Investors will generally favor exploring the cash flow from operations over net income in light of the fact that there is less room to control results. Nonetheless, together, cash flows from operations and net income can give a decent indication of the quality of a firm's earnings.
Current liabilities are liabilities due inside one fiscal year (FY) or operating cycle, whichever is longer. They are found on the balance sheet and are regularly viewed as liabilities due in one year or less.
Grasping the Operating Cash Flow Ratio
The operating cash flow ratio is a measure of the number of times a company can pay off current obligations with cash produced inside a similar period. A high number, greater than one, shows that a company has produced more cash in a period than what is expected to pay off its current liabilities.
An operating cash flow ratio of short of what one demonstrates the inverse — the firm has not created sufficient cash to cover its current liabilities. To investors and analysts, a low ratio could mean that the firm requirements more capital.
Nonetheless, there could be numerous translations, not all of which point to poor financial wellbeing. For instance, a firm might set out on a project that compromises cash flows briefly however delivers substantial rewards from here on out.
The Operating Cash Flow Ratio versus the Current Ratio
Both the operating cash flow ratio and the current ratio measure a company's ability to pay short-term obligations and obligations.
The operating cash flow ratio expects cash flow from operations will be utilized to pay those current obligations (i.e., current liabilities). The current ratio, meanwhile, accepts current assets will be utilized.
Illustration of the Operating Cash Flow Ratio
Consider two goliaths in the retail space, Walmart and Target. As of Feb. 27, 2019, the two had current liabilities of $77.5 billion and $17.6 billion, individually. Over the trailing 12 months, Walmart had produced $27.8 billion in operating cash flow, while Target created $6 billion.
The operating cash flow ratio for Walmart is 0.36, or $27.8 billion partitioned by $77.5 billion. Target's operating cash flow ratio works out to 0.34, or $6 billion isolated by $17.6 billion. The two had comparable ratios, meaning they had comparable liquidity. Digging further, we find that the two shared comparable current ratios too, further approving that they for sure had comparable liquidity profiles.
Limitations of Using the Operating Cash Flow Ratio
Albeit not so pervasive likewise with net income, companies can control operating cash flow ratios. A few companies deduct depreciation expenses from revenue even however it doesn't address a real outflow of cash.
Depreciation expense is an accounting convention that is meant to discount the value of assets over the long haul. Therefore, companies ought to add depreciation back to cash in cash flow from operations.
Highlights
- Cash flow from operations (CFO) is preferred over net income since there is less room to control results through accounting stunts.
- A higher ratio means that a company has produced more cash in a period than what was promptly expected to pay off current liabilities.
- The operating cash flow ratio shows on the off chance that a company's normal operations are adequate to cover its close term obligations.
