Cash Flow Ratios: Examples, Formulas, and Interpretations — Penpoin. (2024)

What’s it:Cash flow ratios arefinancial ratioscalculated by comparing the metrics in the cash flow statement with other items in the financial statements. For example, cash from operations (CFO) is a commonly used metric. It is an alternative to net income. But, unlike net income, the 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 company 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. In addition, the income statement contains several non-cash items, such as depreciation expenses. They do not involve cash inflows and outflows. Thus, the net income obtained does not fully reflect the money posted by the company.

Cash flow ratios give us some insight, including 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 the cash ratio we are using with historical trends. Or, we compare it with a comparison company in the same industry. Such comparisons not only provide a deeper understanding. But, it also allows us to give an objective evaluation.

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 it by income. CFO provides more accurate insights because it represents 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. Then, 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 its success in making money using per $1 asset.

Cash to capital expenditure

Capital expenditure 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 can 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 inthe 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 usually fluctuate greatly from year to year through large and small 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 the CFO on the cash flow statement by net income on the financial statement. Thus, 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 inthe income statement.However, it does not go into cash but accounts receivable onthe balance sheet.

For such reasons, company management may manipulate reported earnings, for example, to secure their bonuses by performing income smoothing. And, this 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. Thus, 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 it 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 can book a higher CFO than expected, its share price will likely 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. This is because 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 is higher, the company generates more cash than it needs to pay off current liabilities. On the other hand, a ratio lower than 1 could indicate liquidity difficulties.

Debt coverage

This ratio measures how much money the company generates in a given year 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 leverage level, and the company has a better ability to pay. The company generates 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 the CFO.

Cash interest coverage

This ratio measures how much cash is generated to cover expenses for interest payments. 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 meeting its current interest payment obligations.

FFO to cash interest

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

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

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

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

A higher ratio is preferred because the company generates enough cash to pay dividends without using money currently held or withdrawing 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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