Cash Flow Ratios: Definition and Formulas

The operating cash flow

operating cash flow
Operating cash flow (OCF) is a measure of the amount of cash generated by a company’s normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion. › terms

ratio is a measure of the number of times a company can pay off current debts with cash generated within the same period. A high number, greater than one, indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities.

An auditor would do well to compute a few straightforward ratios from information on the client’s cash flow statement (the statement of sources and uses of cash) in order to fully understand a company’s viability as an ongoing concern. Without that information, he or she might find themselves in the worst situation imaginable as an auditor, having provided a clean opinion on a client’s financial statements just before it collapses.

Information about cash flows is more trustworthy for analyzing liquidity than balance sheet or income statement data. While the income statement includes numerous arbitrary noncash allocations, such as pension contributions and depreciation and amortization, the balance sheet data are static and measure a single point in time. The cash available for operations and investments is what shareholders are most interested in, so the cash flow statement tracks changes in the other statements and eliminates the accounting ruse.

Ratios have been used for years by Wall Street sharks and credit analysts to mine cash flow statements for useful information. Cash flow ratios play a significant role in the rating decisions made by the major credit-rating agencies. Free cash flow ratios are used by bondholders, particularly junk bond investors, and leveraged buyout experts to describe the risk involved with their investments.

This is so that over time, free cash flow ratios can be used to assess a company’s resilience to price wars or cyclical downturns. If the company’s capital structure had to be revised the last time total cash got just a little below where it is now, the auditor should treat the deficient value like a loud buzzer and consider whether a significant capital expenditure is feasible in a difficult year.

Learning how to use cash flow ratios has been a slow process for many auditors and, to a lesser extent, corporate financial managers. According to our observations, auditors typically take either a balance sheet-based approach or a transaction cycles approach. Neither approach emphasizes cash or the statement of cash flows. Auditor use of ratios for cash-related analysis has been restricted to the current ratio (current assets/current liabilities) or the quick ratio (current assets less inventory/current liabilities), despite the fact that the cash flow statement is used by auditors to verify balance sheet and income statement accounts and to trace common items to the cash flow statement. Despite the fact that the cash flow statement has been required for more than ten years, an informal survey of Big 5 and other national accounting firms found that even today, their audit procedures have not changed in a way that takes advantage of the information presented in the statement.

The failure of W revealed the importance of cash flow ratios. T. Grant. Traditional ratio analysis used during the annual audit failed to detect the severe liquidity issues that soon after led to the filing of a bankruptcy petition. While W. T. Grant had both positive current ratios and positive earnings, but its severely negative cash flows prevented it from meeting its obligations to creditors for current debt and other obligations.

Educators have not been emphasizing the cash flow statement either. With little to no discussion of cash ratios, auditing textbooks frequently only include ratios based on the balance sheet and income statement. As these metrics gain importance in the marketplace, the upcoming generation of auditors needs to learn how to use them in audits. Investors and others are relying on them.

The two types of cash flow ratios that we find most helpful are those that test a company’s solvency and liquidity and those that show whether it can continue to operate. Operating cash flow (OCF), funds flow coverage (FFC), cash interest coverage (CIC), and cash debt coverage (CDC) are the most helpful ratios for the first liquidity indicator. We prefer the following ratios in the second category: total free cash (TFC), cash flow adequacy (CFA), cash to capital expenditures, and cash to total debt.

HOW TO USE CASH FLOW RATIOS TO TEST SOLVENCY Lenders and creditors started utilizing cash flow ratios because they provide more insight into a company’s capacity to meet its payment obligations than do conventional balance sheet working capital ratios like the current ratio or the quick ratio. The biggest worry a loan officer has when assessing the risk she is taking by lending to a specific company is whether that company will be able to repay the loan, plus interest, on time. Traditional working capital ratios show how much cash was available for the company on a specific date in the past. Contrarily, cash flow ratios measure the amount of cash generated over time and compare it to short-term obligations to provide a dynamic picture of the company’s ability to meet its obligations.

Operating cash flow (OCF) ratio. The net cash provided by operating activities makes up the numerator of the OCF ratio. This is the cash flow statement’s net amount after deducting adjustments for noncash items and changes to working capital. All current liabilities from the balance sheet make up the denominator. Operating cash flow ratios vary radically, depending on the industry. Due to the nature of its operations, the gaming industry, for instance, generates significant operating cash flows, whereas more capital-intensive industries, like communications, generate significantly less. The gaming giant, Circus Circus, exhibited an OCF of 1. 737 for the fiscal year 1997, while Gannett, the dominant media company, produced an OCF of 1. 148 for a similar period. An auditor should review comparable ratios for the company’s competitors in the same industry to determine whether a company’s OCF is out of line. (For further details, see the case study. ).

Funds flow coverage (FFC) ratio. Earnings before interest, taxes, depreciation, and amortization (EBITDA), as opposed to operating cash flow, make up the numerator of the FFC ratio. EBITDA does not include cash paid for interest and taxes, but operating cash flow does. If the business can generate enough cash to cover these obligations (interest and taxes), it will be clear from the FFC ratio. Accordingly, interest and taxes are excluded from the numerator. Interest plus tax-adjusted debt repayment plus tax-adjusted preferred dividends make up the denominator. Divide by the complement of the tax rate to account for taxes. All of the figures in the denominator are unavoidable commitments.

The FFC ratio can be used by an auditor as a tool to assess the likelihood that a company will miss its most crucial financial obligations, including interest payments, short-term debt, and preferred dividends (if any). If the FFC ratio is at least 1. 0, the company can meet its commitments—but just barely. Any business that wants to last the long haul needs to generate enough cash flow to maintain its assets. It must be able to reinvest money in order to grow in order to be truly healthy. Accordingly, if a companys FFC is less than 1. In order to meet its current operating commitments, the company must raise additional capital. To avoid bankruptcy, it must keep raising fresh capital.

Cash interest coverage ratio. Cash flow from operations plus interest paid and taxes paid make up the numerator of cash interest coverage. The denominator includes all interest paid—short term and long term. The resulting multiple shows whether the business can afford to pay the interest on its entire debt load. A company with a weak balance sheet will have a low multiple, while one with high leverage will have a high multiple. Any company with a cash interest multiple less than 1. 0 runs an immediate risk of potential default. To pay the company’s current interest obligations, it must raise money from outside sources.

The old-fashioned coverage ratio, also known as the interest coverage ratio, is comparable to the cash interest coverage ratio. Instead of starting with income from the income statement as in the numerator of the coverage ratio, the numerator of the cash interest coverage ratio starts with money from the cash flow statement. A more accurate indication of the company’s ability to make the necessary interest payments is provided by cash interest coverage. Earnings figures take into account a variety of non-cash expenses, including stock options, pension contributions, and depreciation. It may be possible for a company with a low income-based coverage ratio to meet its obligations, but it is difficult to tell because of the noncash charges. The cash available to pay interest is directly reflected by a cash-based coverage ratio.

Cash current debt coverage ratio. Retained operating cash flow—operating cash flow minus cash dividends—makes up the numerator. The denominator is current debt, which is debt with a one-year maturity or less. This is a direct correlation to an earnings current debt coverage ratio once more, but it is more telling because it takes into account the dividend policy of the management and how that affects the cash available to pay off current debt obligations.

HOW TO USE CASH RATIOS AS A MEASURE OF FINANCIAL HEALTH Auditors must assess a client’s capacity to meet ongoing financial and operational commitments as well as its capacity to finance growth in addition to questions of immediate corporate solvency. How quickly will the company be able to raise new capital, maintain or increase its current dividend to stockholders, and repay or refinance its long-term debt?

Capital expenditure ratio. The numerator is cash flow from operations. The denominator is capital expenditures. A financially strong company should be able to finance growth. This ratio gauges the amount of money available for internal reinvestment and debt repayment. When the capital expenditure ratio exceeds 1. 0 The company has sufficient cash on hand to cover its capital expenditures, with some left over to meet debt obligations. The greater the value, the more cash the business has to pay off debt. As with all ratios, appropriate values vary by industry. Noncyclical industries like pharmaceuticals and beverages may exhibit less variation in this number than cyclical industries like housing and automobiles. A low figure is also easier to understand in a developing industry like technology than in a developed industry like textiles.

If all cash flow from operations goes toward debt repayment, this ratio shows how long it will take to pay off the debt. The lower the ratio, the less financial flexibility the business has and the greater the likelihood that future issues will arise. When planning, auditors should consider reduced financial flexibility when identifying high-risk audit areas.

NET FREE CASH FLOW RATIOS The calculation of net free cash flow is a prerequisite for other ratios that highlight a company’s viability as a going concern. Although bankers are working to standardize these computations in a way that would make comparisons across businesses and across industries easier, net free cash flow (NFCF) is not yet clearly defined. However, there are still numerous variations of net free cash flow at the moment. We suggest a total free cash (TFC) ratio created by First Interstate Bank of Nevada, which employs it to decide whether to grant loans and whether to impose loan covenants. By including operating lease and rental payments, this TFC calculation has the advantage of incorporating the effects of off-balance-sheet financing.

TFC ratio . Net income, accrued and capitalized interest expense, depreciation and amortization, operating lease and rental expense, less declared dividends and capital expenditures, make up the ratio’s numerator. The current portion of long-term debt, the current portion of long-term lease obligations, operating lease and rental expense, and accrued and capitalized interest expense make up the denominator.

For instance, the capital spending figure used should exclude new investments and be restricted to the amount of spending necessary to maintain operating assets if the auditor is attempting to determine whether the company can maintain its current level of operations. Up to 5% of property, plant, and equipment is sometimes estimated to represent maintenance spending as a percentage of total assets. Industries with capital assets that last a very long time might estimate maintenance costs using smaller percentages. However, actual capital expenditures from the cash flow statement should be used if the auditor is more concerned with the company’s potential for long-term growth.

Cash flow adequacy (CFA) ratio. Earnings prior to interest, taxes, depreciation, and amortization (EBITDA) is the denominator. The numerator is taxes paid (cash taxes), interest paid (cash interest), and capital expenditures (as defined above). The average annual debt maturities planned over the following five years make up the denominator. Some of the cyclical factors that cause issues with the capital expenditure ratio can be smoothed out by having adequate cash flow. Additionally, it accounts for the consequences of a balloon payment.

KNOW YOUR CLIENT Auditors must be familiar with their clients’ businesses and the industries in which they operate in order to fully understand where to set the thresholds at which the cash flow ratios discussed here should prompt further inquiry. Before getting too alarmed, an auditor should hear the client’s explanation of any unfavorable changes in cash ratios, just like they would with any other ratio. An auditor needs to be aware of the cash issues that are crucial to a company’s operations. We wouldn’t imply that choosing the appropriate equations and entering the numbers is all it takes to conduct a successful audit. There are no absolutes. However, when used correctly, cash flow ratios can be instructive to auditors during the audit planning stages and can provide the auditor with a more accurate picture of the company.

The financial statements must be fairly presented in accordance with GAAP, according to the auditors. They must agree that the four financial statements’ summaries of transactions and balances, as well as the disclosures that go along with them, are accurate. Effective auditors can use cash flow ratios to more fully comprehend the cash concerns that are important to the specific company and to more efficiently plan the audit. Podcast Most Read Features.

Operating Cash Flow Ratio

Importance of cash flow ratios

Cash flow ratios are crucial for a company’s financial analysis. Each ratio reveals a specific financial aspect of the company. A company can use cash flow ratios to determine how much cash it has, where it is going, and what it needs to do to keep its budget balanced.

Because cash flow ratios are straightforward, you can easily add values and obtain results without consulting a financial expert. Because you can use these ratios at any time to obtain results for any time period, they are also very trustworthy. For instance, balance sheets offer useful information, but by the time you analyze them, they may not be current. Utilize a cash flow ratio based on the most recent financial information.

Businesses have the chance to pinpoint various financial issues using cash flow ratios and make improvements. They also focus on the key details a business owner needs to know, like how much cash they have to invest or pay off debts, while also taking interest into account.

What are cash flow ratios?

Calculating the financial health of a business is done using mathematical formulas called cash flow ratios. When attempting to comprehend a company’s profits and losses, cash flow ratios are particularly helpful.

Cash flow refers to the money that a business receives and expends continuously. A company is less vulnerable to financial harm brought on by a decline in its overall business the more cash flow it generates.

Types of cash flow ratios

Businesses use a variety of cash flow ratios to calculate crucial financial data. Depending on the business and its needs in terms of money analysis, some ratios are used more frequently than others.

Think about the standard cash flow ratios used in financial analysis, which are as follows:

Current liability coverage ratio

The current liability coverage ratio determines how much cash a company has on hand to settle debt. This formula determines how much money is required to be paid within a fiscal year or operating cycle. A company should have enough cash on hand to fully cover all of its obligations. If the ratio’s outcome is greater than one, it means that a company has enough cash on hand to cover its current liabilities.

The operating cash flow ratio can be determined using the following formula:

Operating cash flow ratio = Cash from operations / Average Current Liabilities.

Cash flow coverage ratio

The cash flow coverage ratio evaluates a company’s current cash flow and its outstanding debts to determine if it can cover those obligations. The answer indicates how many times a company’s current cash flow can be used to pay both the principal and interest. This gives information about a company’s capacity to pay the outstanding balance.

The cash flow coverage ratio can be calculated using the following formula:

Cash flow coverage ratio: Cash flow from operations divided by total debt.

Price to cash flow ratio

The price of a company share is determined by the stock’s current price when calculating the price to cash flow ratio. The price to cash flow ratio value is significant because it demonstrates the current market value of the company. The ideal price to cash flow ratio is lower, showing that the value of the shares will almost certainly rise. Additionally, it means that even though stock prices aren’t high, the company can survive on its current cash flow.

The price to cash flow ratio can be calculated using the following formula:

Share price/cash flow price per share=price to cash flow ratio

Interest coverage ratio

The interest coverage ratio examines how easily a business can pay its total debt and interest, as well as its interest payments. A business should strive to have a number above one.

Here is the formula for calculating the interest coverage ratio:

Interest coverage ratio equals earnings before interest and taxes divided by interest.

Operating cash flow ratio

This ratio determines how much money a company makes from sales. A preferred operating cash flow number is greater than one because it denotes that a company is profitable and has sufficient funds to continue operating. A company’s cash flow ratio should rise over time as it demonstrates financial growth.

The operating cash flow ratio can be determined using the following formula:

Liabilities / Cash Flow from Operations = Operating Cash Flow Ratio

How to calculate cash flow ratios

There are several ways to calculate cash flow ratios. Here are the key steps to using cash flow ratios:

1. Establish which ratio you want to use

There are particular financial data points required when calculating cash flow ratios. It is helpful to list the amounts you need at the beginning of the calculation to save time. Instead of switching between finding numbers and calculating them, it also enables you to concentrate on one thing at a time. You require the following quantities for the ratios described in this article:

2. Create the mathematical equation

A cash flow ratio requires minimal mathematical division. By layering one amount over the other in accordance with the ratio you want to use, create a cash flow equation. To begin, jot down the official equation on a piece of paper for future use. When you’re ready, use this note to enter the numbers into a calculator.

3. Calculate the amount

Use a calculator to add the values and get results. In the event that the numbers are precise or you’re using averages, you might be able to calculate the ratio on paper.

4. Confirm results

Be sure to update your cash flow ratio calculation to confirm your response. Make sure your response is truthful and trustworthy. Consider comparing outcomes if other coworkers are also collecting data using cash flow ratios.

5. Record answers in data collection software

After performing all necessary calculations, enter the results in your business data collection software. To record these sums, some businesses use spreadsheets, while others manually enter them. Whatever method your company uses to record this information, making a note of each cash flow ratio response is crucial for monitoring changes in cash flow over time.

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