Cash Flow Ratios Analysis: Formula & Example

Cash flow ratios are critical financial tools used by businesses, investors, and analysts to assess the cash position of a company. Unlike traditional profitability ratios, which rely on accrual accounting and may not always represent actual cash received or spent, cash flow ratios focus exclusively on cash movements. They provide a clearer view of a company’s liquidity, operational performance, and ability to meet short-term and long-term obligations.

Cash flow ratios are vital because they determine whether a business has sufficient liquidity to pay for operations, invest in opportunities, and maintain financial stability. They also allow investors to determine the soundness of a company by analyzing how well it generates cash from its operations and other financial activities. Various cash flow-based ratios can be used to provide insights into different aspects of a company's financial health, such as its ability to generate cash, meet obligations, and support shareholder value.

Among the main cash flow ratios are the Cash Flow to Assets Ratio, the Price to Cash Flow Ratio, the Free Cash Flow Ratio, the Cash Flow to Sales Ratio, the Cash Flow Yield Ratio, and the Operating Cash Flow Ratio. These ratios can help identify whether a company is operating efficiently, investing appropriately, and managing its liabilities effectively. Each ratio has a specific purpose, and they are typically derived using a variety of figures from a company’s cash flow statement, balance sheet, and income statement.

The Cash Flow to Assets Ratio is an important tool to measure how effectively a business uses its assets to generate cash flows. It is calculated by dividing the cash flow from operations by the average of opening and closing assets over a specific period. This ratio provides insight into the company’s efficiency in managing its assets and converting them into cash. A higher Cash Flow to Assets Ratio indicates that the business is generating a strong cash position relative to its assets, which is a positive indicator of financial health.

Another essential cash flow ratio is the Price to Cash Flow Ratio, which is calculated by dividing the market price per share by the cash flow per share. This ratio measures how much investors are willing to pay for each unit of cash flow generated by the company. It serves as a useful valuation tool because cash flow is harder to manipulate than profits, which makes this ratio more reliable when assessing the intrinsic value of a company. A lower Price to Cash Flow Ratio generally suggests that the stock may be undervalued, while a higher ratio could imply that the stock is overvalued.

The Free Cash Flow Ratio is another significant cash flow-based measure. This ratio is calculated by subtracting dividends paid and the net value of any planned asset purchases from cash generated through operations. Free cash flow represents the cash available to a company after it has met its operational and capital expenditure needs. This ratio is an indicator of financial flexibility because it shows how much cash is left over after all necessary expenses have been accounted for. It can be used to determine whether a business has the ability to invest in growth opportunities, pay down debt, or distribute dividends to shareholders.

The Cash Flow to Sales Ratio is a ratio that compares operating cash flow to net sales. This ratio is a way to assess how effectively a business converts its sales into cash. High ratios indicate that a company generates more cash from each dollar of sales, while lower ratios suggest potential liquidity problems or inefficiencies in collecting receivables. It serves as a measure of operational efficiency and indicates how well the business is converting revenue into cash to support day-to-day expenses and investments.

Similarly, the Cash Flow Yield Ratio measures the relationship between cash flow from operations and net profits. It provides a way to evaluate how much cash is being generated by a company's operations compared to its reported profits. Net profits are based on accrual accounting and can be influenced by non-cash items like depreciation, amortization, or write-offs, which means this ratio offers a more practical view of cash performance. A high Cash Flow Yield Ratio suggests that a business has good cash generation capabilities, while a lower ratio could highlight discrepancies between profitability and actual cash flows.

The Operating Cash Flow Ratio is a critical liquidity ratio that compares operating cash flow to current liabilities. It assesses whether a company can meet its short-term obligations with cash generated from its core operations. This ratio is vital for determining the short-term liquidity of a business, as it shows if a company has enough cash flow to pay its current liabilities without relying on external financing. A higher Operating Cash Flow Ratio indicates strong liquidity, while a lower ratio suggests potential cash flow issues or an over-reliance on borrowing to meet financial obligations.

These ratios collectively provide a well-rounded view of a company’s cash generation abilities, liquidity, operational performance, and financial health. Cash flow ratios are preferred by analysts and investors because cash is a more reliable indicator of financial strength than accounting profits, which can be affected by estimates, accounting choices, or non-cash items. Companies with strong cash flow ratios typically enjoy advantages such as easier access to financing, a greater ability to weather economic downturns, and a stronger foundation for strategic growth and expansion.

When evaluating cash flow ratios, it is important to consider industry benchmarks and historical trends. Different industries have varying levels of capital intensity, debt, and cash flow needs. Comparing a company's cash flow ratios to those of similar companies within the same industry can provide context for the analysis. Additionally, trends in cash flow ratios over time can reveal whether a company is improving its cash generation ability, managing liabilities effectively, or facing liquidity challenges.

In conclusion, cash flow ratios are invaluable financial metrics for assessing a company's liquidity, operational efficiency, and overall financial health. They are essential tools for both management and investors when determining the stability, profitability, and long-term growth potential of a business. Understanding and interpreting the Cash Flow to Assets Ratio, Price to Cash Flow Ratio, Free Cash Flow Ratio, Cash Flow to Sales Ratio, Cash Flow Yield Ratio, and Operating Cash Flow Ratio allows stakeholders to make informed decisions about investment, financing, and operational strategies. As businesses continue to operate in dynamic and competitive markets, maintaining a strong cash flow position is vital to achieving financial sustainability and operational success.

Below are the main cash flow-based financial ratios and the calculations:

Formula:
1) Cash Flow to Assets Ratio = Cash flow from operations / Opening assets + Closing assets / 2
2) Price to Cash Flow Ratio = Market price per share / Cash flow per Share
3) Free Cash Flow Ratio = Cash from operations - dividends paid - (Purchase value of planned assets - Sale value of planned assets)
4) Cash Flow to Sales Ratio = Operating Cash Flow / Net Sales
5) Cash Flow Yield Ratio = Cash flow from operations / Net Profits
6) Operating Cash Flow Ratio = Cash flow / Current liabilities

Learn how to calculate and analyze cash flow ratios with the following examples:

Example 1:
PPP Company has total cash flow of $25 million and the current liabilities are $28 million. Then, the operating cash flow ratio would be: 25 million / 28 million = 0.89. This means that the company is not making enough money to pay its bills and other short term liabilities.

Example 2:
Golden Ltd has the following information for the year ended 31 December 2010: Net Cash Provided by Operating Activities $800,000; Sales $5,100,000; Sales returns $100,000.
Then,
Net sales = 5,100,000 - 100,000 = $5,000,000
Cash Flow to Sales = 800,000 / 5,000,000 = 0.16
This means that cash generated for each dollar of sales is $0.16