Operating Cash Flow Ratio

What Is the Operating Cash Flow Ratio?

The operating cash flow ratio is a measure of how readily current liabilities are covered by the cash flows generated from a company's operations. This ratio can help gauge a company's liquidity in the short term.

Using cash flow as opposed to net income is considered a cleaner or more accurate measure since earnings are more easily manipulated.

The Formula for the Operating Cash Flow Ratio

Operating cash flow ratio = Operating cash flow Current liabilities \text{Operating cash flow ratio} = \frac {\text{Operating cash flow}}{\text{Current liabilities}} Operating cash flow ratio=Current liabilitiesOperating cash flow

The operating cash flow ratio is calculated by dividing operating cash flow by current liabilities. Operating cash flow is the cash generated by a company's normal business operations. 

Operating Cash Flow Ratio Components

A company generates revenues — and deducts the cost of goods sold (COGS) and other associated operating expenses, such as attorney fees and utilities, from those revenues. Cash flow from operations is the cash equivalent of net income. It is the cash flow after operating expenses have been deducted and before the commencement of new investments or financing activities.

Investors tend to prefer reviewing the cash flow from operations over net income because there is less room to manipulate results. However, together, cash flows from operations and net income can provide a good indication of the quality of a firm's earnings. 

Current liabilities are all liabilities due within one fiscal year (FY) or operating cycle, whichever is longer. They are found on the balance sheet and are typically regarded as liabilities due within one year.

Understanding the Operating Cash Flow Ratio

The operating cash flow ratio is a measure of the number of times a company can pay off current debts with cash generated within the same period. A high number, greater than one, indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities.

An operating cash flow ratio of less than one indicates the opposite — the firm has not generated enough cash to cover its current liabilities. To investors and analysts, a low ratio could mean that the firm needs more capital.

However, there could be many interpretations, not all of which point to poor financial health. For example, a firm may embark on a project that compromises cash flows temporarily but renders substantial rewards in the future.

The Operating Cash Flow Ratio vs. the Current Ratio

Both the operating cash flow ratio and the current ratio measure a company’s ability to pay short-term debts and obligations.

The operating cash flow ratio assumes cash flow from operations will be used to pay those current obligations (i.e., current liabilities). The current ratio, meanwhile, assumes current assets will be used.

Example of the Operating Cash Flow Ratio

Consider two giants in the retail space, Walmart and Target. As of Feb. 27, 2019, the two had current liabilities of $77.5 billion and $17.6 billion, respectively. Over the trailing 12 months, Walmart had generated $27.8 billion in operating cash flow, while Target generated $6 billion.

The operating cash flow ratio for Walmart is 0.36, or $27.8 billion divided by $77.5 billion. Target’s operating cash flow ratio works out to 0.34, or $6 billion divided by $17.6 billion. The two had similar ratios, meaning they had similar liquidity. Digging deeper, we find that the two also shared similar current ratios as well, further validating that they indeed had similar liquidity profiles.

Limitations of Using the Operating Cash Flow Ratio

Although not as prevalent as with net income, companies can manipulate operating cash flow ratios. Some companies deduct depreciation expenses from revenue even though it does not represent a real outflow of cash.

Depreciation expense is an accounting convention that is meant to write off the value of assets over time. As a result, companies should add depreciation back to cash in cash flow from operations.