What is Operating Cash Flow Ratio?

1165 reads · Last updated: September 26, 2023

The operating cash flow ratio is a measure of how readily current liabilities are covered by the cash flows generated from a company's operations. This ratio can help gauge a company's liquidity in the short term.Using cash flow as opposed to net income is considered a cleaner or more accurate measure since earnings are more easily manipulated.

Operating Cash Flow Ratio

Definition

The operating cash flow ratio measures a company's ability to cover its current liabilities with the cash flow generated from its daily operations. This ratio helps investors and analysts assess the company's short-term liquidity. Compared to net income, using cash flow is considered a more reliable metric because profits can be more easily manipulated.

Origin

The concept of the operating cash flow ratio originated in the late 20th century. With advancements in financial analysis techniques and increased demands for financial transparency from investors, this ratio has become an important tool for evaluating a company's financial health. Particularly after several major financial scandals, investors have placed greater emphasis on cash flow rather than solely relying on net income.

Categories and Characteristics

The operating cash flow ratio mainly includes the following types:

Basic Operating Cash Flow Ratio: The formula is operating cash flow divided by current liabilities. A higher ratio indicates a stronger ability to cover short-term liabilities with cash flow from operations.
Adjusted Operating Cash Flow Ratio: This ratio adjusts for non-recurring items, providing a more accurate reflection of the company's actual operating condition.

Specific Cases

Case 1: A company has an operating cash flow of $5 million and current liabilities of $3 million in 2023. Its operating cash flow ratio is 5/3 = 1.67. This indicates that the company has sufficient cash flow to cover its short-term liabilities, suggesting good liquidity.

Case 2: Another company has an operating cash flow of $2 million and current liabilities of $4 million in the same year. Its operating cash flow ratio is 2/4 = 0.5. This suggests that the company may face short-term debt repayment pressure, indicating poor liquidity.

Common Questions

Q1: What is considered a healthy operating cash flow ratio?
A1: Generally, an operating cash flow ratio greater than 1 is considered healthy, indicating that the company has sufficient cash flow to cover its short-term liabilities.

Q2: Why is the operating cash flow ratio more reliable than net income?
A2: Because the cash flow ratio is based on actual cash movements, whereas net income can be influenced by accounting policies and practices, leaving room for manipulation.

Suggested for You

Refresh

Sensitivity Analysis

Sensitivity analysis shows how different values of an independent variable affect a dependent variable under a given set of assumptions. Companies use sensitivity analysis to identify opportunities, mitigate risk, and communicate decisions to upper management.Sensitivity analysis is deployed in business and economics by financial analysts and economists and is also known as a "what-if" analysis.

Sensitivity Analysis

Sensitivity analysis shows how different values of an independent variable affect a dependent variable under a given set of assumptions. Companies use sensitivity analysis to identify opportunities, mitigate risk, and communicate decisions to upper management.Sensitivity analysis is deployed in business and economics by financial analysts and economists and is also known as a "what-if" analysis.

Gross Working Capital

Gross working capital is the sum of a company's current assets (assets that are convertible to cash within a year or less). Gross working capital less current liabilities is equal to net working capital, or simply "working capital;" a more useful measure for balance sheet analysis.

Gross Working Capital

Gross working capital is the sum of a company's current assets (assets that are convertible to cash within a year or less). Gross working capital less current liabilities is equal to net working capital, or simply "working capital;" a more useful measure for balance sheet analysis.

Gross Income Multiplier

A gross income multiplier (GIM) is a rough measure of the value of an investment property. It is calculated by dividing the property's sale price by its gross annual rental income. Investors can use the GIM—along with other methods like the capitalization rate (cap rate) and discounted cash flow method—to value commercial real estate properties like shopping centers and apartment complexes.

Gross Income Multiplier

A gross income multiplier (GIM) is a rough measure of the value of an investment property. It is calculated by dividing the property's sale price by its gross annual rental income. Investors can use the GIM—along with other methods like the capitalization rate (cap rate) and discounted cash flow method—to value commercial real estate properties like shopping centers and apartment complexes.

Gross Margin Return On Investment

The gross margin return on investment (GMROI) is an inventory profitability evaluation ratio that analyzes a firm's ability to turn inventory into cash above the cost of the inventory. It is calculated by dividing the gross margin by the average inventory cost and is used often in the retail industry. GMROI is also known as the gross margin return on inventory investment (GMROII).

Gross Margin Return On Investment

The gross margin return on investment (GMROI) is an inventory profitability evaluation ratio that analyzes a firm's ability to turn inventory into cash above the cost of the inventory. It is calculated by dividing the gross margin by the average inventory cost and is used often in the retail industry. GMROI is also known as the gross margin return on inventory investment (GMROII).

Statement Of Retained Earnings

The statement of retained earnings (retained earnings statement) is a financial statement that outlines the changes in retained earnings for a company over a specified period. This statement reconciles the beginning and ending retained earnings for the period, using information such as net income from the other financial statements, and is used by analysts to understand how corporate profits are utilized.The statement of retained earnings is also known as a statement of owner's equity, an equity statement, or a statement of shareholders' equity. Boilerplate templates of the statement of retained earnings can be found online. It is prepared in accordance with generally accepted accounting principles (GAAP).

Statement Of Retained Earnings

The statement of retained earnings (retained earnings statement) is a financial statement that outlines the changes in retained earnings for a company over a specified period. This statement reconciles the beginning and ending retained earnings for the period, using information such as net income from the other financial statements, and is used by analysts to understand how corporate profits are utilized.The statement of retained earnings is also known as a statement of owner's equity, an equity statement, or a statement of shareholders' equity. Boilerplate templates of the statement of retained earnings can be found online. It is prepared in accordance with generally accepted accounting principles (GAAP).

Liquidity risk refers to the potential difficulty an entity may face in meeting its short-term financial obligations due to an inability to convert assets into cash without incurring a substantial loss. This risk is inherent in both financial institutions and corporations, significantly impacting their operational and financial stability.Liquidity risk is often characterized by two main aspects: market liquidity risk and funding liquidity risk. Market liquidity risk is associated with an entity's inability to execute transactions at prevailing market prices due to insufficient market depth or disruptions. On the other hand, funding liquidity risk pertains to the inability to obtain sufficient funding to meet financial obligations.Liquidity risk is not confined to any particular sector, as it is an important consideration across banks, financial institutions, corporations, and even some individual investors. For banks and financial institutions, liquidity risk management is underscored by regulatory frameworks that mandate certain liquidity standards to ensure financial stability and protect depositor interests. Corporations, too, need to be vigilant in managing liquidity risk to ensure they have adequate cash or credit lines to meet their operational and financial commitments. The ability to manage liquidity risk is essential for ensuring it has enough cash on hand to meet its short term needs and obligations.

Liquidity Risk

Liquidity risk refers to the potential difficulty an entity may face in meeting its short-term financial obligations due to an inability to convert assets into cash without incurring a substantial loss. This risk is inherent in both financial institutions and corporations, significantly impacting their operational and financial stability.Liquidity risk is often characterized by two main aspects: market liquidity risk and funding liquidity risk. Market liquidity risk is associated with an entity's inability to execute transactions at prevailing market prices due to insufficient market depth or disruptions. On the other hand, funding liquidity risk pertains to the inability to obtain sufficient funding to meet financial obligations.Liquidity risk is not confined to any particular sector, as it is an important consideration across banks, financial institutions, corporations, and even some individual investors. For banks and financial institutions, liquidity risk management is underscored by regulatory frameworks that mandate certain liquidity standards to ensure financial stability and protect depositor interests. Corporations, too, need to be vigilant in managing liquidity risk to ensure they have adequate cash or credit lines to meet their operational and financial commitments. The ability to manage liquidity risk is essential for ensuring it has enough cash on hand to meet its short term needs and obligations.