What is the Operating Cash Flow Ratio?
The Operating Cash Flow Ratio is a tool that measures how well a company can cover its current liabilities with cash generated from operations. This ratio can be used to estimate a company’s short-term liquidity.
This ratio is a more accurate measure of a company’s financial health than net income, because net income figures are more susceptible to accounting fraud.
Calculation and Meaning
- How to Calculate: Simply divide Operating Cash Flow by Current Liabilities.
- Meaning of the Result: The higher the ratio, the more cash the company has available to pay its current liabilities. What a powerful sign!
How do you calculate the operating cash flow ratio?
This ratio is very easy to calculate.
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
What it means
- Operating Cash Flow is the amount of cash a company actually receives from its normal business operations.
- This amount is divided by its current liabilities to get this ratio.
In other words, this “cash flow test” is done to see how easily a company can pay off its short-term debts with the cash it receives from its operations.
Components of the Operating Cash Flow Ratio
Operating Cash Flow
A company deducts from its revenues the cost of goods sold and operating expenses, such as attorney fees, utilities, and water.
- Cash Flow from Operations is the cash equivalent of Net Income.
- It is the cash flow remaining after deducting operating expenses and before making new investments or financing activities.
Why do investors like it?
Investors are more likely to look at Cash Flow from Operations than Net Income because it is less susceptible to fraud. However, when you look at the two together, they can provide a good indication of a company’s earnings quality.
Current Liabilities
Current liabilities are all debts that are due to be paid within one fiscal year or operating cycle (whichever is longer).
- This information can be found on a company’s balance sheet and is usually defined as debts that are due within one year.
Reading the Operating Cash Flow Ratio: What Does It Mean for Your Business?
The Operating Cash Flow Ratio is a measure of how many times a company can pay its current liabilities with the cash it receives during the current period.
- If the ratio is greater than one (e.g. 1.2, 2.0): This is a good sign. It shows that the company is generating more cash than it needs to pay its current liabilities.
- If the ratio is less than one (e.g. 0.8): This shows the opposite. It means that the company is not generating enough cash to cover its current liabilities. To investors and analysts, a low ratio can mean that the company needs more capital.
However, there are different interpretations when reading this ratio. Not every low number means a bad financial situation. For example, a company may be embarking on a major project that will generate significant future profits, which could temporarily affect cash flow.
Comparing Operating Cash Flow Ratio and Current Ratio
Both the Operating Cash Flow Ratio and the Current Ratio are ratios that measure a company’s ability to pay its short-term debts and obligations.
The main difference between the two is the currency in which they are assumed to be used.
- Operating Cash Flow Ratio: This ratio assumes that cash flow from operating activities will be used to pay current liabilities.
- Current Ratio: This ratio assumes that cash flow from current assets will be used to pay current liabilities.
Looking at the Operating Cash Flow Ratio
Let’s look at the situation of two large retail companies, Walmart and Target.
As of February 27, 2019, their balance sheets are as follows:
- Walmart had $77.5 billion in current liabilities and $27.8 billion in operating cash flow (OCF).
- Target had $17.6 billion in current liabilities and $6 billion in OCF.
Walmart’s ratio: $27.8 billion divided by $77.5 billion gives 0.36.
Target’s ratio: $6 billion divided by $17.6 billion gives 0.34.
These two companies have very similar ratios. This means that their short-term liquidity is also similar. Upon further inspection, their Current Ratios are also similar, further confirming that the two are indeed in the same financial situation.
Understanding the Limitations of the Operating Cash Flow Ratio
Although it is not as significant as net income, companies can manipulate the operating cash flow ratio.
- For example, some companies deduct depreciation expenses from income.
- In fact, depreciation expense is not a real outflow of cash, but is used to show the decrease in the value of assets in the inventory over time.
Therefore, when calculating cash flow from operations, companies should add this depreciation expense back to cash. This will give a more accurate picture of the real cash situation.
The Bottom Line
The operating cash flow ratio (OCF ratio) is an essential tool for assessing a company’s short-term liquidity. This ratio shows how well a company can cover its current liabilities with cash generated from operations.
The higher the OCF ratio, the stronger the company’s cash position. A lower ratio may indicate that additional capital is needed or that a strategic project is being undertaken that will yield a profit. Investors prefer OCF to Net Income because OCF is less susceptible to manipulation.
Also Read: Cash Flow Management: Basics, Tips, and Best Practices
Both the OCF ratio and the Current ratio are useful in assessing a company’s short-term ability to pay its debts. However, they are calculated differently. OCF uses cash flow, while the Current ratio uses current assets. In order to perform accurate financial analysis, It is very important to understand the limitations of the OCF ratio, which can be manipulated by non-cash expenses such as depreciation.
