Operating Cash Flow Ratio

Ratio analysis of a firm’s financial input and output serves as a useful measure to assess its performance and profitability. Resultantly, entrepreneurs and business analysts utilise several financial metrics like operating cash flow ratio to gauge the economic health and viability of businesses.

However, one must note that each of such financial metrics accounts for a distinct source of cash flow in business and helps to ascertain different aspects of a company, namely – liquidity, profitability or sustainability.

What is Operating Cash Flow Ratio?

Essentially, operating cash flow ratio or cash flow from operations is a liquidity ratio. It helps to understand the capability of a firm to cover its current liabilities with the cash generated from core operations.

In other words, it helps to determine how much earnings a company generates through its operating activities against each unit of current liabilities.

To ascertain this ratio, individuals are required to find out the cash flow resulting from the primary business operation. Usually, the same is recorded in the company cash flow statement. On the other hand, one can easily find out the current liability of a firm by glancing through the balance sheet.

Operating Cash Flow Ratio Formula

Operational cash flow ratio is computed by dividing cash flow resulting from core operations by the firm’s current liabilities.

Operating cash flow ratio formula is written as –

OCF Ratio = Cash flow from core operation / Current liabilities

Here, operation cash flow includes –

Revenue accrued through operations + Non-cash-oriented expenditure – Non-cash-oriented revenue.

Whereas, Current liabilities include creditors, accrued expenses, short-term loans, etc.

Example of Operating Cash Flow Ratio

Take a look at this example below to understand how liquidity is computed with the help of this ratio.

As per the cash flow statement, the cash flows from operating activities during that period was Rs. 4,73,87,000.

So, with the help of the formula –

OCF Ratio = Cash flow from core operation / Current liabilities

= 4,73,87,000 / 9,07,03,100

= 0.522

This shows a weak financial standing or capability to pay off short-term liabilities.

Operating Cash Flow Ratio Analysis

Ideally, a higher ratio is considered better, as this financial metric helps to determine the number of times a firm’s liabilities can be readily paid off from net operating cash flow.

Generally, a ratio over 1 is considered to be desirable, while a ratio lower than that indicates strained financial standing of the firm.

Use of Operating Cash Flow Ratio

These pointers below highlight the fundamental uses of cash flow from operations ratio –

• The OCF ratio serves as a useful measure of a firm’s liquidity or the ability to clear the immediate short-term debt.
• It helps to ascertain the earnings the company has generated through its primary business operations.
• This ratio comes in handy for business analysts and potential investors and helps them to compare businesses that are similar in their operational activities.
• Generally, companies prefer operating cash flow over net income as there is less room to tweak or manipulate the outcome.

Limitations of Using Cash Flow Ratio

These are some noteworthy limitations of cash flow ratio –

• This ratio can be easily manipulated.
• For a proper financial analysis, companies should use this ratio along with other ratios.
• A low OCF ratio does not always indicate a poor financial standing of a company. So, potential investors and analysts have to be extra careful when analysing this ratio or the company’s debt management capability general.

Consequently, individuals should factor in both the advantages and limitations of this ratio to arrive at an accurate result.

Difference between Current Ratio and Operating Cash Flow Ratio

Both operating cash flow ratio and current ratio are quite similar in terms of their purpose. However, each of them uses a distinct approach to determine a firm’s current financial standing.

Take a look at this table below to understand their differences better –

Lastly, it can be said that operating cash flow ratio is a useful financial metric that comes in handy for both businesses and potential investors. Regardless, financial analysts recommend individuals to use other financial measures and data for a thorough financial analysis.