It’s easy to see that financial statements contain a lot of data, but making sense of that data is not so easy. Teasing out connections between the numbers can unlock their meaning and help you understand where your business has been, where it’s headed, and how you can improve its prospects.
Measure the Financial Health of a Company
You probably know that cash flow is crucial for a company’s long-term viability. The operating cash flow ratio (CFR) helps assess how a company’s cash flow compares to its obligations, which is a sign of its solvency. Can it pay its current liabilities from the cash flow generated by core business operations? This is a key indicator of the business’ financial health.
Calculate the Operating Cash Flow Ratio
To compute the CFR, you need to know two numbers: cash provided by operating activities, or operating cash flow, found on the statement of cash flows, and current liabilities (those due within one year), found on the balance sheet. Divide operating cash flows by current liabilities to get the cash flow ratio..
For example, if your business had $30,000 of operating cash flow and $90,000 of current liabilities as of the end of the fiscal year, your cash flow ratio would be 0.33.
A ratio of less than 1 indicates the company cannot meet its obligations through business operations, and is a warning signal. Conversely, a ratio higher than 1 indicates that the company can meet its current liabilities with cash left over — an indicator that is welcomed by investors and creditors.
Several factors affect the CFR:
- Increased profit yields a higher operating cash flow, lifting the CFR. This holds as long as the higher profit isn’t due to lower depreciation expense. Depreciation is a non-cash cost and has no effect on operating cash flow or the CFR.
- Reducing accounts receivable and inventory balances through better working capital management increases operating cash flow, which raises the CFR.
- Increasing liabilities such as accounts payable by negotiating longer payment terms with suppliers increases operating cash flow, which raises the CFR.
- Decreasing liabilities by repaying a short-term bank loan has no effect on operating cash flow but decreases current liabilities and increases the CFR.
Evaluate the Operating Cash Flow Ratio
To put the cash flow ratio in context, you can do three types of comparisons: period-to-period contrasts, peer-to-peer comparisons, and relationship to other ratios.
Period-to-Period Cash Flow Ratio Contrasts
Let’s say two companies, SlowCo and ChaosCo, have the same operating cash flow and current liabilities as your business in the example above. For year one, all three companies have a 0.33 CFR. But at the end of the following year, your company’s new CFR is 0.55, SlowCo’s is 1.13, and ChaosCo’s is negative 0.27.
In order for ChaosCo’s CFR to drop to a negative number, their operating cash flow must be insufficient to pay their current liabilities. The company should spend a considerable amount of time investigating the causes, which might include lower profits, increased accounts receivable or inventory balances, or increased liabilities. A period-to-period contrast is a good starting point that indicates there may be a problem, but it’s going to take a bit of work to see how to get the company back on track.
With period-to-period trends, you compare one measure within the same company over multiple periods. Your company’s CFR improved, from 0.33 to 0.55, which, absent other information, does not raise any flags and is a positive sign. SlowCo’s CFR improved by a healthy amount, while ChaosCo’s situation appears to have declined at an alarming rate. You’d want to dig further into what caused these significant changes from one year to the next.
Peer-to-Peer Cash Flow Ratio Comparisons
With peer-to-peer comparisons, you compare ratios among similar companies to identify outliers. In the example above, you’d likely want to understand what makes SlowCo’s performance so different from ChaosCo’s. This is a very useful comparison, as studying your competitors is a great way to gain a competitive advantage. If you’re able to spot what gives your competitors a crucial advantage, you can then explore how you can implement some of their strategies to take your business to the next level. Likewise, competitors at a disadvantage can be useful examples and may present you with new opportunities.
Compare Cash Flow Ratio to Other Ratios
A third technique involves exploring the relationship between multiple ratios. To complement the CFR, you could look into performance or working capital ratios. For example, with SlowCo, you might see that sales decreased from one year to the next, or perhaps the company improved how it managed accounts receivable and inventory. These changes would raise CFR. With ChaosCo, you might see a significant increase in sales, but one that was coupled with much higher accounts receivable and inventory balances. If you were a creditor or supplier to this company, you’d want to monitor how well it was managing its growth.
The CFR is a useful solvency indicator. Keeping an eye on this ratio and other business metrics can provide you with important insight into a company’s ability to pay its bills. This is true whether the company is your own or one with whom you do business. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.