Cash Reinvestment Ratio

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Description: The cash reinvestment ratio is useful for determining the amount of cash flow that a company is routinely plowing back into the business. On the one hand, this can be indicative of a strong commitment by the owners to build the business. However, it can also mean that a company is being so poorly run that it requires an excessive amount of working capital and fixed assets in order to stay in business.

Formula: To calculate the ratio, summarize cash flow for the period, subtract out any dividends paid, and then divide the result by the combined incremental increase in both fixed assets and working capital. When determining the incremental increase in fixed assets, be sure to factor out the net impact of any fixed asset sales during the period – otherwise, the incremental increase in assets due to the acquisition of assets will appear to be deflated. An alternative calculation is to eliminate changes in working capital from the numerator, which allows one to focus on only key investments being made in a company’s plant and equipment. The formula is as follows:

Increase in Fixed Assets + Increase in Working Capital
Net Income + Noncash Expenses – Noncash Sales - Dividends

Example: An investor wants to determine the amount of cash flow reinvestment for a target company. It is in a growth industry, and a high rate of reinvestment is expected. The ratio is:

Increase in fixed assets + Increase in working capital
Net income + Noncash expenses - Noncash sales - Dividends

$250,000 + $450,000
$1,200,000 + $125,000 - $28,000 - $50,000

$700,000
$1,247,000

= 56%

Cautions: As noted in the description, this ratio can be an indicator of either a continuing commitment to a business, or of mis-management that requires a continual addition of assets to stay in business. To see if the underlying issue is related to mismanagement, you can calculate the ratio of fixed assets to revenue, and see how this correlates to the same ratio for other businesses in the same industry. The ratio of working capital to sales can be used in the same fashion. If these ratios indicate unusually high proportions of assets or working capital within the business, then there is either some mis-management of assets, or the company’s operational structure is so different from other businesses that their results are not comparable.