Operating Cash Flow Ratio - Explained
What is Operating Cash Flow Ratio?
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Table of ContentsWhat is Operating Cash Flow Ratio?How is Operating Cash Flow Ratio Used?What does operating cash flow ratio signify?Key PointsExample of using the operating cash flow ratioOperating cash flow ratio vs Current ratioDrawbacks of using operating cash flow ratioAcademic Research on Operating Cash Flow Ratio
What is Operating Cash Flow Ratio?
The operating cash flow ratio ascertains if the cash flows obtained from the operations of a firm are adequate to cover the current liabilities. This ratio enables in knowing the liquidity of an organization in the short-run. Because of the easy manipulation of the company's earnings, the cash flow is deemed as a more reliable approach than net income. One can calculate operating cash flow ratio by dividing operating cash flow with current liabilities of a firm. The formula of operating cash flow ratio is:
Operating cash flow ratio= Operating cash flow / Current liabilities
Back to: ACCOUNTING, TAX, & REPORTING
How is Operating Cash Flow Ratio Used?
By selling its products and services, a firm earns revenues which are deducted from the cost of goods sold (COGS) and the related operating costs including utilities and attorney costs. Cash flow from operations is equal to the cash generated from net income. Operating cash flow from operations refers to the cash flow after subtracting the operating costs, and prior to putting their money in investing or financing activities. When investors have to check a company's credibility, they prefer analyzing the cash flow from operating activities rather than net income because of lesser chances of manipulating data. However, if they analyze both cash flow from operations and net income, it can show a better picture about the earnings of a company. Current liabilities are the liabilities that a company needs to pay within a year or one operating period, whichever appears to be of longer duration. They lie on the balance sheet of a company, and are usually considered as liabilities due within a year.
What does operating cash flow ratio signify?
The operating cash flow ratio tells the number of times a firm can manage paying off its current liabilities using cash within the same time. If the value stands to be more than one, it signifies that the company has enough cash, or more cash than the amount required to be paid off as current liabilities. However, if the operating cash flow ratio tends to be less than unity, it states that the company is not having much cash to pay off its current liabilities. Investors and financial analysts may consider that the organization requires more capital. However, the low operating cash flow ratio should not always be related with the poor financial position of a firm. For instance, a company can start a project that requires more cash flows in the short-term but still offers a huge scope of offering huge rewards in the long-run.
- The operating cash flow ratio is a tool to measure how effectively cash flows from operations can cover current liabilities.
- If the ratio is more than 1, it infers that the firm has more cash to pay off its liabilities due within a year.
- Cash flow from operations appears to be more favorable than net income because of lesser possibility of manipulating outputs.
Example of using the operating cash flow ratio
Lets assume that the current liabilities of Walmart was $77.5 billion, and Target was $17.6 billion respectively as of Feb. 27, 2019. In the time period of a year, Walmart had operating cash flow of $27.8 billion, and Target had that of $6 billion. Considering the formula for operating cash flow ratio, the ratio will be 0.36 ($27.8 billion / $77.5 billion) for Walmart, and 0.34 for Target ($6 billion / $17.6 billion). As the ratios are almost same in numbers, it means that both the companies have same liquidity position as well. If further calculations are made, well find that the current ratio of both the firms is same indicating that both of them share same liquidity profiles.
Operating cash flow ratio vs Current ratio
The common feature of operating cash flow ratio and current ratio is that they both help in measuring the short-term debts and liabilities that a company owes to its debtors. While calculating the operating cash flow ratio, cash flow from operations are considered to pay off current liabilities, while for calculating the current ratio, the company uses its current assets.
Drawbacks of using operating cash flow ratio
Companies can still manage manipulating operating cash flow ratios, if not as much as net income. There are some firms who exclude depreciation costs from revenues even if it doesn't reflect a real cash outflow. Depreciation expense refers to the gradual writing off the value of assets over a period of time. Ultimately, firms should follow the policy of adding depreciation expense to cash while calculating cash flow from operations.
Academic Research on Operating Cash Flow Ratio