Cash Flow Ratio: Examples, Formulas and Interpretation

By | January 27, 2022

What it is: A cash flow ratio (cash flow ratio) is a financial ratio calculated by comparing the metrics in the cash flow statement with other items in the financial statements. Cash from operations (CFO) is a commonly used metric. It is an alternative to net income. But, unlike net income, CFO provides a more accurate picture of how much money a company is making.

We can then compare it to other financial metrics such as income, debt, and interest expense. In valuation, we also use CFO to calculate the P/CF ratio as an alternative to the P/E ratio.

Why are cash flow ratios important?

We use the cash flow ratio to determine the company’s overall financial performance. We can use several ratios to learn more about a company’s finances.

Some analysts prefer cash flow ratios over other ratios based on items on the income statement. Under accrual accounting, profit is not the same as cash. The income statement contains several non-cash items such as depreciation expense. They do not involve cash inflows and outflows. Thus, the net income obtained does not fully reflect the money recorded by the company.

Cash flow ratios give us some insight, including about how much money a company owns and makes. Next, we can also track where the money is going and answer questions like:

  • How well is the company using its assets to make money?
  • Has the company managed to convert its revenue into sufficient cash? Or, is it actually more tied to the consumer?
  • How good is the company’s liquidity? And, how well is the company’s ability to meet interest and debt payments through the cash it generates?
  • How much cash is generated to cover capital expenditures and support future growth?
  • How attractive is a company’s stock when we relate it to its ability to make money?

Then, we can compare our cash ratios with historical trends. Or, we compare them with comparison companies in the same industry. Such comparisons not only provide a deeper understanding. But, it also allows us to give an objective assessment.

What are the commonly used cash flow ratios?

A commonly used cash flow metric is cash flow from operations (CFO). However, some analysts may use other metrics such as Funds from operations (FFO) and free operating cash flow (FOCF). Then, we compare them with other financial indicators, including the company’s stock price.

Cash flow to revenue

Conceptually, this ratio is similar to the net profit margin. But, instead of using net income, we use CFO as the numerator. We then divide by income. CFOs provide more accurate insights because they represent the amount of money a company makes from its core operations.

  • Cash flow to revenue = CFO / Revenue

Cash flow to revenue measures how successfully the company converts its revenue into cash. A higher ratio is preferable because the company can raise more money for each dollar of its revenue.

Cash return on assets (cash ROA)

Cash return on assets is similar to return on assets. But, we replace net income with CFO. We divide it by the average total assets in the last two years.

  • Cash return on assets = CFO / Average total assets

Cash ROA measures how well a company uses its assets to make money. Thus, a higher ratio is more desirable because it indicates the success of the company in making money using per $1 of asset.

Cash to capital expenditure

Capital spending is important to sustain long-term growth. And, the company hopes to make more money through it.

The cash to capital expenditure ratio measures how able the company is to finance capital expenditures using the cash generated in the same period. We calculate it by dividing cash flow from operations by capital expenditures. Both can be found in the cash flow statement .

  • Cash to capital expenditure = CFO / Capital expenditure

A higher ratio indicates the company is making enough money to finance capital expenditures. But, indeed, it will typically fluctuate greatly from year to year through major and minor capital expenditure cycles.

Cash flow to net income

Cash flow to net income is a metric to evaluate the quality of a company’s earnings. We calculate it by dividing CFO on the cash flow statement by net income on the financial statement. It shows whether the net profit posted by the company in a given year is consistent with the money it makes.

  • Cash flow to net income = CFO / Net income

As I have already mentioned, under accrual accounting profit is not the same as money earned. Thus, the company may report high profits but poor cash. For example, it’s because more revenue is owed by the customer. Thus, the company recorded revenue in the income statement . But, it does not go into cash but accounts receivable on the balance sheet .

For such reasons, company management may manipulate reported earnings, for example to secure their bonuses by performing income smoothing. And, the cash flow to net income ratio is one way to detect it. A ratio close to one indicates such a practice is less likely to occur.

Cash flow per share

Cash flow per share is similar to earnings per share (EPS). Only, it used the money made from the operation. We calculate it by dividing CFO, adjusted for preferred dividends, by the number of common shares outstanding. It shows how much money is available for each share held.

  • Cash flow per share = (CFO – Preferred dividends) / Number of common shares outstanding

A higher ratio indicates the company is making more money available to common stockholders.

Price-to-cash-flow ratio

Unlike the P/E ratio, the price-to-cash-flow ratio (P/CF ratio) is not easy to manipulate because it uses a realistic indicator, namely CFO. Meanwhile, the P/E ratio uses net income, which is vulnerable to manipulation under accrual accounting.

The P/CF ratio relates the company’s shares to cash from operations. It shows us how attractive a company’s stock is, relating it to its ability to generate cash.

We calculate this ratio by dividing the company’s stock price by the CFO per share. Then, to get CFO per share, we divide CFO by the number of common shares outstanding.

  • P/CF ratio = Price per share / CFO per share

A high ratio shows investors are willing to pay dearly for the company’s prospects in the future. They expect the company to make more money in the future.

  • However, a high ratio can also indicate an overvalued stock. Thus, when the future CFO is below expectations, the stock price is likely to correct downwards.

Meanwhile, a high ratio can indicate investor pessimism about the company’s prospects in generating profits. Thus, they are not willing to pay a higher price.

  • Alternatively, it could also indicate an undervalued stock. So, if the company is able to book a higher CFO than expected, its share price is likely to go up high.

Operating cash flow ratio

This ratio is similar to the cash ratio. However, we do not use the most liquid money and assets currently held by the company. Instead, we use the money made in a year.

We calculate this ratio by dividing CFO by current liabilities. The formula is as follows:

  • Operating cash flow ratio = CFO / Current liabilities

A higher ratio is more desirable. It shows a better ability to cover current liabilities using the money generated in the same period.

The ideal ratio is close to one. If it’s higher, it indicates the company is generating more cash than it needs to pay off current liabilities. On the other hand, a ratio lower than 1 may indicate liquidity difficulties.

Debt coverage

This ratio measures how much money the company generates in a given year can be used to pay off outstanding debt. We calculate it by dividing CFO by total debt.

  • Debt coverage = CFO / Total debt

A higher ratio is more desirable. It shows a low level of leverage and the company has a better ability to pay. The company makes enough money to pay back its debts as they fall due.

Another alternative to calculating debt coverage is to use funds from operations (FFO) or free operating cash flow (FOCF).

  • FFO to debt (%) = FFO / Total debt
  • FOCF to debt (%) = FOCF / Total debt

Both are commonly used by corporate credit rating analysts. FFO represents cash available before being used for expenses for routine operations, capital expenditures, and discretionary items such as dividends and acquisitions. Meanwhile, FOCF, sometimes called free cash flow, is calculated by subtracting capital expenditure from CFO.

Cash interest coverage

This ratio measures how much cash is generated to cover expenses to pay interest. Here is the formula:

  • Cash interest coverage = (CFO + Interest paid + Taxes paid) / Interest paid

A higher ratio is preferred because the company generates sufficient cash to pay interest. Ideally, it is more than 1. If it is lower, it could indicate the company’s difficulty in meeting its current interest payment obligations.

FFO to cash interest

Some interest charges may not require cash payments. An example is the payment of non-cash interest on payment-in-kind instruments. So, instead of using interest charge as a denominator, we use cash interest. Whereas, for counters, we use FFO.

  • FFO to Cash interest (x) = FFO / Cash Interest

The ratio measures how many times the money generated by the company can be used to pay cash interest. Higher multiples are more desirable, indicating the firm is making more money relative to money to pay interest expense.

Dividend payment

This ratio shows the company’s security in paying dividends. It is linked to the money made in the same year. We calculate it by dividing CFO by dividends paid.

  • Dividend payment = CFO / Dividend paid

Higher ratios are preferred because the company generates enough cash to pay dividends without having to use money currently held or withdraw short-term investments. Ideally, it is more than one so, the company can use the rest for other purposes such as capital expenditures.

 

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