Operating cash flow ratio

The operating cash flow ratio measures the funds generated and used by the core operations of a business. It is used to evaluate the ability of a business to pay for its short-term liabilities. 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 = Operating cash flow ratio

The cash flows from ancillary activities are excluded from this calculation. If ancillary cash flows were to be included in operating cash flows, it would imply that the entity is relying on non-core activities to support its core activities. 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 Courses

Business Ratios Guidebook 
The Interpretation of Financial Statements