A cash flow ratio can be used in addition to traditional net income accounting ratios to provide useful comparative information about a business. Net income is a subjective measure which is based on accounting principles and opinions; for example the amount of depreciation and bad debt allowance will influence the level of net income. On the other hand cash flow is an objective measure which is simply the difference between the cash in and the cash out of the business and therefore more difficult to manipulate.
The ratios are based on cash flow from operating activities which is a measure of the cash flow generated by the trading operations of the business.
There are many cash flow ratios including the three listed below
- Cash flow to net income
- Cash flow margin
- Asset efficiency ratio
Cash Flow to Net Income Ratio
The cash flow to net income ratio, sometimes referred to as cash flow yield, is calculated by dividing the operating cash flow of the business by its net income.
The formula for calculating the cash flow to net income ratio is shown below.
- Cash flow from operating activities is from the cash flow statement of the business.
- Net income is from the income statement.
The cash flow to net income ratio measures the ability of a business to generate cash from its operations and ideally should be greater than 1.00. Since cash is an objective measure the ratio is also used to indicate the quality of the earnings.
Cash Flow to Net Income Ratio Example
Suppose a business has the following income statement and cash flow statement for its current financial year.
| Revenue | 200,000 |
| Cost of goods sold | 90,000 |
| Gross profit | 110,000 |
| Operating expenses | 50,000 |
| Depreciation | 13,343 |
| Operating income | 46,657 |
| Finance costs | 956 |
| Income before tax | 45,701 |
| Income tax expense | 9,140 |
| Net income | 36,561 |
| Net income | 36,561 |
| Add back depreciation | 13,343 |
| Working capital | -3,497 |
| Operating activities | 46,407 |
| Capital expenditure | -10,000 |
| Investing activities | -10,000 |
| Debt repayments | -11,716 |
| Financing activities | -11,716 |
| Net cash flow | 24,691 |
| Beginning cash balance | 14,552 |
| Ending cash balance | 39,343 |
To illustrate, in the example above the cash flow from operating activities is 46,407 and the net income is 36,561. Accordingly the calculation of the cash flow ratio is as follows.
Cash flow from operating activities = 46,407Net income = 36,561Cash flow to net income ratio = Cash flow from operating activities / Net incomeCash flow to net income ratio = 46,407 / 36,561Cash flow to net income ratio = 1.27
The calculation shows that the business generates 1.27 of cash for every 1.00 generated in net income.
Real Life Cash Ratio Example Using Apple Inc.
Furthermore similar calculations can be made using any published sets of financial information. For example using the financial statements of Apple Inc. for 2016 the ratio can be calculated as follows.
Cash flow from operating activities = 65,824Net income = 45,687Cash flow to net income ratio = Cash flow from operating activities / Net incomeCash flow to net income ratio = 65,824 / 45,687Cash flow to net income ratio = 1.44
The calculation shows that Apple Inc. generated 1.44 of cash for every 1.00 generated in net income.
Cash Flow Margin Ratio
The cash flow margin is a measure of the ability of a business to generate cash from its sales revenue. The ratio is calculated by dividing the operating cash flow of the business by its sales.
Cash flow margin ratio = Cash flow from operating activities / Sales
- Cash flow from operating activities is shown in the cash flow statement of the business.
- Sales revenue is shown in the income statement.
There is no absolute correct value for the cash flow margin. It should be in line with industry standards and ideally remain stable, indicating that the cash generated by the business is rising in line with the increase in sales.
The cash flow margin ratio is equivalent to the traditional net margin ratio using cash flow from operating activities instead of net income.
Cash Flow Margin Example
Using the information in the financial statements shown above the cash flow from operating activities is again 46,407 and the sales revenue is 200,000. The cash flow ratio is calculated by using the formula as follows.
Cash flow from operating activities = 46,407Sales = 200,000Cash flow margin ratio = Cash flow from operating activities / SalesCash flow margin ratio = 46,407 / 200,000Cash flow margin ratio = 23.2%
The calculation shows that the operating cash flow represents 23.2% of sales.
Real Life Cash Flow Ratio Example Using Apple Inc.
Using the financial statements of Apple Inc. for 2016 the cash flow ratio can be calculated as follows.
Cash flow from operating activities = 65,824Sales = 215,639Cash flow margin ratio = Cash flow from operating activities / SalesCash flow margin ratio = 65,824 / 215,639Cash flow margin ratio = 30.5%
Apple Inc. operating cash flow represents 30.5% of its sales revenue.
Asset Efficiency Ratio
The asset efficiency ratio is used to indicate how efficiently the assets of the business are being used to generate cash. The ratio is calculated by dividing the operating cash flow of the business by its total assets.
Asset efficiency ratio = Cash flow from operating activities / Total assets
- Cash flow from operating activities is shown in the cash flow statement of the business.
- Total assets is shown in the balance sheet.
The asset efficiency ratio is equivalent to the traditional return on assets ratio using cash flow from operating activities instead of operating income.
Asset Efficiency Ratio Example
The calculation of the asset efficiency ratio requires information from the balance sheet which is shown below.
| Cash | 39,243 |
| Accounts receivable | 24,657 |
| Inventory | 7,397 |
| Current assets | 71,297 |
| Long term assets | 31,133 |
| Total assets | 102,430 |
| Accounts payable | 14,795 |
| Other liabilities | 9,879 |
| Current liabilities | 24,674 |
| Long-term debt | 12,185 |
| Total liabilities | 36,859 |
| Capital | 15,000 |
| Retained earnings | 50,571 |
| Total equity | 65,571 |
| Total liabilities and equity | 102,430 |
For simplicity the calculations below are carried out using information from the ending balance sheet. In practice when calculating ratios using balance sheet information it is always best if possible to try and use the average of the information from the beginning and ending balance sheets to avoid distorting the calculations.
Using the information highlighted in the cash flow statement and balance sheet shown above, the cash flow from operating activities is again 46,407 and the total assets is 102,430. The ratio is calculated by using the formula as follows.
Cash flow from operating activities = 46,407Total assets = 102,430Asset efficiency ratio = Cash flow from operating activities / Total assetsAsset efficiency ratio = 46,407 / 102,430Asset efficiency ratio = 45.3%
The cash flow from operating activities represents 45.3% of the total assets of the business.
Real Life Cash Flow Ratio Example Using Apple Inc.
Using the financial statements of Apple Inc. for 2016 the ratio can be calculated as follows.
Cash flow from operating activities = 65,824Total assets = 321,686Asset efficiency ratio = Cash flow from operating activities / Total assetsAsset efficiency ratio = 65,824 / 321,686Asset efficiency ratio = 20.5%
Apple Inc. operating cash flow represents 20.5% of its total assets.
Cash Flow Ratio Summary
The net income of a business used in the calculation of traditional ratios is subjective and can be distorted by accounting assumptions and opinions used in its formulation. By using cash flow from operating activities as an objective measure it is possible to calculate cash flow ratios which supplement traditional ratios to give a better understanding of the performance and operation of a business.
As with all ratios the value in their use is obtained by observing the trend in the ratio over time and by comparing the ratios with industry standards and with companies operating in a similar environment.
Last modified January 9th, 2023 by Michael Brown
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.
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Posted By: Michael Brown Accounting Ratios, Cash Flow, Ratio Formula
January 9, 2023
Accounting Ratios Basics
As someone deeply immersed in the realm of finance and accounting, it's evident that the understanding of cash flow ratios and their implications is crucial for assessing the financial health and operational efficiency of a business. Drawing upon my extensive expertise, I'll delve into the concepts highlighted in the provided article.
Cash Flow to Net Income Ratio: The cash flow to net income ratio, or cash flow yield, serves as a robust metric for gauging a business's ability to generate cash from its operations. This ratio is calculated by dividing the operating cash flow by the net income. The formula is straightforward:
[ \text{Cash Flow to Net Income Ratio} = \frac{\text{Cash Flow from Operating Activities}}{\text{Net Income}} ]
Ideally, this ratio should exceed 1.00, indicating that the business is generating more cash than reported in net income. In the example provided, the calculated ratio for the sample business is 1.27, demonstrating its ability to generate $1.27 in cash for every $1.00 of net income.
Real-Life Example - Apple Inc.: Applying the same methodology to Apple Inc.'s financial statements for 2016, the cash flow to net income ratio is calculated as 1.44. This implies that Apple generated $1.44 in cash for every $1.00 of net income during that period.
Cash Flow Margin Ratio: The cash flow margin ratio measures a business's capability to generate cash from its sales revenue. It is computed by dividing the operating cash flow by the sales revenue:
[ \text{Cash Flow Margin Ratio} = \frac{\text{Cash Flow from Operating Activities}}{\text{Sales}} ]
In the provided example, the calculated cash flow margin ratio for the sample business is 23.2%, indicating that the operating cash flow represents 23.2% of its sales.
Real-Life Example - Apple Inc.: Utilizing Apple Inc.'s financials for 2016, the cash flow margin ratio is calculated as 30.5%, signifying that Apple's operating cash flow represents 30.5% of its sales revenue.
Asset Efficiency Ratio: The asset efficiency ratio assesses how efficiently a business's assets are utilized to generate cash. This ratio is determined by dividing the operating cash flow by the total assets:
[ \text{Asset Efficiency Ratio} = \frac{\text{Cash Flow from Operating Activities}}{\text{Total Assets}} ]
In the provided example, the calculated asset efficiency ratio for the sample business is 45.3%, indicating that the cash flow from operating activities represents 45.3% of its total assets.
Real-Life Example - Apple Inc.: Applying the same approach to Apple Inc.'s financial statements for 2016, the asset efficiency ratio is calculated as 20.5%, suggesting that Apple's operating cash flow represents 20.5% of its total assets.
Summary: In conclusion, these cash flow ratios, grounded in the objective measure of cash flow from operating activities, provide valuable insights into a business's financial performance and operational efficiency. It's essential to consider these ratios in tandem with traditional metrics, observe trends over time, and benchmark against industry standards for a comprehensive evaluation. Michael Brown, a seasoned chartered accountant, emphasizes the significance of these ratios in gaining a nuanced understanding of a business's dynamics.
