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    Saturday
    Jun152013

    Operating cash flow ratio definition and usage

    Ideally, the bulk of the cash flow generated by a business should come from its core operations. The cash flows from ancillary activities should be quite minor. Otherwise, the entity is relying on non-core activities to support its core activities.

    The calculation of the operating cash flow ratio first calls for the derivation of cash flow from operations, which requires the following calculation:

    + Income from operations
    + Non-cash expenses
    - Non-cash revenue
    = Cash flow from operations 

    An example of non-cash revenue is deferred revenue that is being recognized over time, such as an advance payment on services that will be provided over several months.

    Once cash flow from operations has been derived, we then divide it by the total net income for the entity. The calculation is:

    Cash flow from operations
    Net income

    Ideally, the ratio should be fairly close to 1:1. A much smaller ratio indicates that a business is deriving much of its cash flow from sources other than its core operating capabilities.

    Example of the Operating Cash Flow Ratio

    Blitz Communications recently raised $50 million through an initial public offering, and promptly parked all of the cash in investments. In the following quarter, the company’s net income rose from $400,000 to $900,000. Further investigation reveals the following cash flow from operations ratio:

      Preceding Quarter Current Quarter
    Cash flow from operations $390,000 $375,000
    Net income $400,000 $900,000
    Cash flow from operations ratio 98% 42%

     
    The ratio reveals that the core operations of the business have generated less cash than had been the case before the company went public. The entire source of the increased net income has been the investment income generated by the cash the company obtained from investors when it went public.

    Related Topics

    Cash coverage ratio 
    Cash ratio 
    Cash reinvestment ratio 
    Margin of safety 
    Working capital productivity