Cash flow ratios are those comparisons of cash flows to other elements of an entity’s financial statements. A higher level of cash flow indicates a better ability to withstand declines in operating performance, as well as a better ability to pay dividends to investors. These ratios are especially important when evaluating companies whose cash flows diverge substantially from their reported profits. Some of the more common cash flow ratios are:
- Cash flow coverage ratio. Calculated as operating cash flows divided by total debt. This ratio should be as high as possible, which indicates that an organization has sufficient cash flow to pay for scheduled principal and interest payments on its debt.
- Cash flow margin ratio. Calculated as cash flow from operations divided by sales. This is a more reliable metric than net profit, since it gives a clear picture of the amount of cash generated per dollar of sales.
- Current liability coverage ratio. Calculated as cash flows from operations divided by current liabilities. If this ratio is less than 1:1, a business is not generating enough cash to pay for its immediate obligations, and so may be at significant risk of bankruptcy.
- Price to cash flow ratio. Calculated as the share price divided by the operating cash flow per share. This ratio is qualitatively better than the price/earnings ratio, since it uses cash flows instead of reported earnings, which is harder for a management team to falsify.
- Cash flow to net income. A proportion close to 1:1 indicates that an organization is not engaging in any accounting trickery intended to inflate earnings above cash flows.