A liquidity ratio that measures a company's ability to pay off its current liabilities with its cash flow
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What is the Operating Cash Flow Ratio?
The Operating Cash Flow Ratio, a liquidity ratio, is a measure of how well a company can pay off its current liabilities with the cash flow generated from its core business operations. This financial metric shows how much a company earns from its operating activities, per dollar of current liabilities. Since earnings involve accruals and can be manipulated by management, the operating cash flow ratio is considered a very helpful gauge of a company’s short-term liquidity.
Formula
The formula for calculating the operating cash flow ratio is as follows:
Where:
- Cash flow from operations can be found on a company’s statement of cash flows. Alternatively, the formula for cash flow from operations is equal to net income + non-cash expenses + changes in working capital.
- Current liabilities are obligations due within one year. Examples include short-term debt, accounts payable, and accrued liabilities.
What is Cash Flow From Operations?
It is important to understand cash flow from operations (also called operating cash flow) – the numerator of the operating cash flow ratio.
Operating cash flow (OCF) is one of the most important numbers in a company’s accounts. It reflects the amount of cash that a business produces solely from its core business operations. Operating cash flow is intensely scrutinized by investors, as it provides vital information about the health and value of a company. If a company fails to achieve a positive OCF, the company cannot remain solvent in the long term. A negative OCF indicates that a company is not generating sufficient revenues from its core business operations, and therefore needs to generate additional positive cash flow from either financing or investment activities.
Example of the Operating Cash Flow Ratio
The following information was taken out of Company A’s Q2 financial statements:
To calculate the ratio at the end of the second quarter:
Therefore, the company earns $1.25 from operating activities, per dollar of current liabilities. Alternatively, it can be viewed as, “Company A can cover its current liabilities 1.25x over.”
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Interpretation of Operating Cash Flow Ratio
If the ratio is less than 1, the company generated less cash from operations than is needed to pay off its short-term liabilities. This signals short-term problems and a need for more capital. A higher ratio – greater than 1.0 – is preferred by investors, creditors, and analysts, as it means a company can cover its current short-term liabilities and still have earnings left over. Companies with a high or uptrending operating cash flow are generally considered to be in good financial health.
Key Takeaways
- The operating cash flow ratio is a liquidity ratio that measures how well a company can pay off its current liabilities with cash generated from its core business operations.
- This liquidity ratio is considered an accurate measure of short-term liquidity, as it only uses cash generated from core business operations rather than from all income sources.
- A ratio less than 1 indicates short-term cash flow problems; a ratio greater than 1 indicates good financial health, as it indicates cash flow more than sufficient to meet short-term financial obligations.
Learn More
We hope you have enjoyed reading CFI’s guide to the operating cash flow ratio. To learn more about cash flow and financial analysis, we suggest the following CFI resources:
FAQs
What Is the Operating Cash Flow Ratio? 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.
What is the best operating cash flow ratio? ›
The operating cash flow ratio represents a company's ability to pay its debts with its existing cash flows. It is determined by dividing operating cash flow by current liabilities. A ratio greater than 1.0 indicates that a company is in a strong position to pay its debts without incurring additional liabilities.
How do I calculate operating cash flow? ›
How to calculate the operating cash flow formula
- Operating cash flow = total cash received for sales - cash paid for operating expenses.
- OCF = (revenue - operating expenses) + depreciation - income taxes - change in working capital.
- OCF = net income + depreciation - change in working capital.
Operating Cash Flow Ratio Analysis
Generally, a ratio over 1 is considered to be desirable, while a ratio lower than that indicates strained financial standing of the firm.
What is a good operating cash flow margin ratio? ›
What is a good operating cash flow margin? A good operating cash flow margin is typically above 50%. If a company has an operating cash flow margin of below 50%, this suggests that the company is not efficiently making sales into cash, and instead, may have high expenses.
What is a bad operating cash flow ratio? ›
If the ratio is less than 1, the company generated less cash from operations than is needed to pay off its short-term liabilities. This signals short-term problems and a need for more capital.
What is a healthy price to cash flow ratio? ›
A good price-to-cash-flow ratio is any number below 10. Lower ratios show that a stock is undervalued when compared to its cash flows, meaning there is a better value in the stock.
What is an example of operating cash flow? ›
Examples of the direct method of cash flows from operating activities include: Salaries paid out to employees. Cash paid to vendors and suppliers. Cash collected from customers.
Is operating cash flow the same as Ebitda? ›
No, they are not the same. Cash flow from operations includes changes in working capital, while EBITDA excludes these changes.
Is operating cash flow the same as net income? ›
Key Takeaways. Net Income is the result of revenues minus the expenses, taxes, and costs of goods sold (COGS). Operating cash flow is the cash generated from operations, or revenues, less operating expenses. Many investors and analysts prefer using operating cash flow as an indicator of a company's health.
Operating Cash Flow = Net Income + Depreciation & Amortization + Stock-Based Compensation + Deferred Tax + Other Non-Cash Items – Increase in Accounts Receivable – Increase in Inventory + Increase in Accounts Payable + Increase in Accrued Expenses + Increase in Deferred Revenue.
What is the difference between cash flow and operating cash flow? ›
Key Takeaways. Operating cash flow measures cash generated by a company's business operations. Free cash flow is the cash that a company generates from its business operations after subtracting capital expenditures.
What is a good operating cash flow to sales ratio? ›
What is a good cash flow to sales ratio? A cash flow to sales ratio is considered good if it falls between 10% and 55%.
How to calculate operating cash flow percentage? ›
Step 1 → Calculate Cash Flow from Operating Activities. Step 2 → Calculate Net Revenue. Step 3 → Divide Operating Cash Flow by Revenue. Step 4 → Multiply by 100 to Convert to Percentage Form.
How to find the operating cash flow? ›
Indirect method
The indirect method formula is:Operating cash flow = (revenue – cost of sales) + depreciation – taxes +/- change in working capitalWhere: Revenue is the amount of money an organization earns from sales during the accounting period.
What percentage is a good cash flow? ›
Well, while there's no one-size-fits-all ratio that your business should be aiming for – mainly because there are significant variations between industries – a higher cash flow margin is usually better. A cash flow margin ratio of 60% is very good, indicating that Company A has a high level of profitability.
What is the best operating ratio? ›
The ideal OER is between 60% and 80% (although the lower it is, the better).
What is the ideal cash flow coverage ratio? ›
In most industries, the example above would be a prime example of a good cash flow coverage ratio. Generally, businesses aim for a minimum of 1.5 to comfortably pay debt with operating cash flows.
What is the ideal cash operating cycle? ›
The optimal cash conversion cycle (CCC) varies by industry and business nature. Generally, a lower CCC is considered better as it indicates efficient management of working capital. However, the appropriate target CCC varies by industry, and businesses should aim to improve their CCC over time.
