What is the Operating Cash Flow Ratio?
The operating cash flow ratio is an essential metric for assessing how effectively a company can cover its current liabilities using the cash flows generated from its core business operations. This measurement is pivotal for understanding a company’s short-term liquidity and overall financial health.
Key Takeaways
- The operating cash flow ratio demonstrates whether a company’s standard operating activities generate sufficient cash to meet its short-term obligations.
- A higher ratio indicates that more cash is generated than required to cover immediate liabilities, showcasing strong liquidity.
- Cash flow from operations (CFO) is preferred over net income, offering a more accurate reflection of a company’s financial status since it’s less prone to manipulation.
The Formula for the Operating Cash Flow Ratio
Operating Cash Flow Ratio = \frac{Operating Cash Flow}{Current Liabilities}
This ratio is computed by dividing the operating cash flow by the current liabilities. Operating cash flow represents the cash generated through a company’s usual business activities.
Components of the Operating Cash Flow Ratio
A company’s revenue minus the cost of goods sold (COGS) and other operational expenses such as legal and utility costs results in the cash flow from operations. This figure signals the net income in cash terms after deducting operating expenses but before engaging in new investments or financing activities.
Investors favor cash flow from operations over net income because it is less susceptible to accounting manipulations. However, both metrics together provide valuable insights into a company’s earnings quality.
Current liabilities include all liabilities due within one fiscal year or operating cycle, whichever is longer, as reported on the company’s balance sheet.
Understanding the Operating Cash Flow Ratio
This ratio quantifies how many times a company can settle its current debts using fresh cash generated in the same period. A ratio greater than one signifies that the company has a healthy cash flow that surpasses its outstanding liabilities for that period.
Conversely, a ratio below one implies the company can’t fully cover its current liabilities from its current-period cash flow, indicating potential liquidity issues. However, a low ratio doesn’t necessarily signify poor financial health; it might also indicate that the firm is investing heavily in projects that promise future gains.
Operating Cash Flow Ratio vs. Current Ratio
Both ratios measure a company’s capability to settle short-term obligations, but they do so differently. The operating cash flow ratio focuses on utilizing cash from operations, while the current ratio depends on current assets fulfilling current liabilities.
Example of the Operating Cash Flow Ratio
Consider two retail titans, Walmart and Target. As of February 27, 2019, Walmart had current liabilities of $77.5 billion and generated $27.8 billion in operating cash flow over the previous 12 months, resulting in an operating cash flow ratio of 0.36. Target, with $17.6 billion in current liabilities and $6 billion in operating cash flow, presented a ratio of 0.34. Despite their size differences, both companies demonstrated similar liquidity profiles validated through their corresponding current ratios.
Limitations of the Operating Cash Flow Ratio
Although harder to manipulate than net income, operating cash flow ratios can still be tweaked. For example, companies may deduct non-cash expenses like depreciation from revenue. Since depreciation doesn’t represent actual cash outflow, it should be added back to cash in operating cash flow calculations.
Related Terms: current liabilities, net income, current ratio, cash flow.
