# Cash reinvestment ratio

The cash reinvestment ratio is used to estimate the amount of cash flow that management reinvests in a business. While a high cash reinvestment ratio might initially appear to indicate that management is committed to improving the business, it could also mean that an excessive amount of investment in fixed assets and working capital is required to run the operation. Thus, the measure can be misleading, unless coupled with other metrics to obtain a more complete picture of company operations.

In particular, compare the company's ratio of fixed assets to revenues to those of well-run companies in the industry, as well as the ratio of working capital to revenues. If these ratios indicate better performance by the peer group, there is a strong likelihood that the subject company is investing more cash than necessary.

The formula for the cash reinvestment ratio requires you to summarize all cash flows for the period, deduct dividends paid, and divide the result into the incremental increase during the period in fixed assets and working capital. Additional points regarding the formula are:

• Fixed asset sales. If any fixed assets are sold during the measurement period, factor out the impact of the sale.
• Working capital elimination. A variation on the formula is to exclude working capital changes from the numerator. Doing so focuses attention solely on new fixed asset additions.

The formula is:

(Increase in fixed assets + Increase in working capital) ÷
(Net income + Noncash expenses – Noncash sales - Dividends)

For example, a prospective investor wants to calculate the rate of cash flow reinvestment for a possible investee. The investee is in a rapidly-expanding industry, so major reinvestment is normal. The ratio is:

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

=

(\$350,000 + \$550,000) ÷
(\$1,700,000 + \$140,000 - \$20,000 - \$40,000)

=

\$900,000 ÷ \$1,780,000 = 51%

Related Courses