The operating cash flow ratio, also known as the cash flow coverage ratio, is a financial indicator that assesses a company’s capacity to generate enough cash flow from its activities to meet its short-term obligations. It assesses a company’s liquidity and financial health by comparing operating cash flow to current obligations.
Calculate the Operating Cash Flow Ratio
The formula to calculate the operating cash flow ratio is:
Operating Cash Flow Ratio= Operating Cash Flow/Current Liabilities
Where:
- Operating Cash Flow (OCF) represents the cash generated by a company’s basic operating activities. It is computed by adjusting net income to account for non-cash expenses and working capital movements.
- Current Liabilities contain liabilities due within the next 12 months, such as accounts payable, short-term debt, and accrued expenses.
Interpretation of the Operating Cash Flow Ratio
1) Increased Ratio:
- A ratio larger than one implies that the company generates enough operating cash flow to meet its current liabilities. This shows that the company has sufficient liquidity to meet its short-term obligations without relying substantially on external funding or asset sales.
2) Lower Ratio:
- A ratio less than one indicates that the company may struggle to produce enough cash from operations to meet its present liabilities. This could signal liquidity issues and difficulties in satisfying short-term financial obligations.
Importance of the Operating Cash Flow Ratio
1) Liquidity Assessment:
- It is a more conservative measure of liquidity than current and quick ratios, which consider non-cash assets. Allows investors and creditors to evaluate the company’s capacity to manage day-to-day operations and financial obligations.
2) Financial Health Indicator:
- A stable operating cash flow ratio shows effective working capital management and long-term financial stability.
Limitations of the Operating Cash Flow Ratio
1) Dependence on Industry Norms:
- Optimal ratios might vary by business, thus it’s critical to compare a company’s ratio to industry norms for relevant analysis.
2) Potential manipulation:
- Companies might alter cash flow by aggressive accounting methods, which has an impact on ratio accuracy.
Example:
Assume a corporation has an operating cash flow of $500,000 and current liabilities of $400,000. The operating cash flow ratio will be computed as:
Operating Cash Flow Ratio = 500,000/400,000 =1.25
This means that the company generates $1.25 in operating cash flow for every $1 in current liabilities, indicating strong liquidity and financial health to fulfill short-term obligations.
Conclusion:
The operating cash flow ratio gives useful information about a company’s capacity to meet its short-term financial obligations through core operations. By evaluating this ratio with other liquidity and financial data, stakeholders can make more informed decisions about investment, lending, and the company’s overall financial health.
