Operating cash flow ratio definition
/What is the Operating Cash Flow Ratio?
The operating cash flow ratio measures the ability of a business to pay for its current liabilities from its reported operating cash flows. The best-case scenario is when the ratio reveals operating cash flows that are several multiples of the liabilities that must be settled. Conversely, a low ratio indicates that cash flows may not be sufficient to settle all obligations as they come due, which could indicate an impending solvency issue. This ratio is a good tool for lenders and creditors, especially when evaluating smaller or new borrowers.
How to Calculate the Operating Cash Flow Ratio
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.
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Once cash flow from operations has been derived, we then divide it by the total current liabilities for the entity. The calculation is:
Cash flow from operations ÷ Current liabilities = Operating cash flow ratio
In the calculation, cash flow from operations comes from a firm’s statement of cash flows. Current liabilities are all liabilities stated on a firm’s balance sheet that are due for payment within one year. Any 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.
Example of the Operating Cash Flow Ratio
According to its statement of cash flows, Blitz Communications generated $2,500,000 of operating cash flow during its most recent reporting period. Its balance sheet as of the end of that period shows current liabilities of $1,500,000. This results in an operating cash flow ratio of 1.67. The comparison shows that the company should be generating sufficient cash flows to pay off its current liabilities.
Advantages of the Operating Cash Flow Ratio
A key advantage of the operating cash flow ratio is that cash flows are generally considered to be a better indicator of financial condition than a firm’s reported profits. When a business uses the accrual basis of accounting, it may include non-cash entries in the derivation of profits, so the firm is reporting profits even when its cash flows may be negative.
Disadvantages of the Operating Cash Flow Ratio
A potential problem with this ratio is the possibility that a reporting entity could manipulate its derivation of cash flow from operations. This figure is indirectly derived from operating income and non-cash transactions, so the deliberate alteration of any of these components could result in a cash flow figure that does not reflect reality. For example, a business might not subtract out non-cash revenue, resulting in more cash flow from operations than is really the case.
Another concern is that the ratio can indicate the presence of problems when there is no real issue. For example, a business might have spent considerable amounts to start up a new product line, from which it has not yet started generating any income. During this presumably short period of time, the firm will show low operating cash flow, while the obligations from constructing the new product line will still be high. The situation should resolve itself once the product line starts operating.
Operating Cash Flow Ratio vs. Current Ratio
The operating cash flow ratio and current ratio can both be used to determine the ability of an organization to pay its current obligations. However, there is a crucial difference between the two measures; the operating cash flow ratio assumes that cash flows from operations will be the source of funds for those payments, while the current ratio assumes that current assets will be the source of funds.