Last updated on
2024年5月6日
How do you calculate the operating cash flow ratio and what does it tell you about a business?
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Operating cash flow (OCF) is the amount of cash that a business generates from its core activities, such as selling goods or services, paying salaries, and buying supplies. It excludes cash flows from investing or financing activities, such as buying or selling assets, issuing or repaying debt, or paying dividends. OCF reflects how well a business can generate cash from its operations without relying on external sources of funding.
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I think in order to control Cash Flow from OFC you need to dig a little deeper and divide OFC into cash flow from income, and cash flow from variation from assets and liabilities. In that way, you can differentiate the cash coming from sales, from the cash from variation from assets and liabilities.
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In my opinion, the companies during its operating cicle can have troubles with its liquidity and the same can be for a short period. They need money to continue with its activities, that way it is important to have a rotating credit line, so that debt must be consider as part of the OCF.
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Calculating the operating cash flow ratio involves assessing a company's ability to generate cash from its core operations. Typically, it's computed by dividing operating cash flow by total sales revenue. This ratio offers valuable insights into a business's liquidity and financial health. A higher ratio indicates that a company is efficiently converting its sales into cash, which suggests strong operational performance and financial stability. Conversely, a lower ratio may signal potential liquidity issues or inefficiencies in operations. Understanding this metric is crucial for investors and stakeholders as it provides a snapshot of a company's ability to sustain its operations and meet its financial obligations.
The operating cash flow ratio is calculated by dividing the OCF by the current liabilities. Current liabilities are the obligations that a business has to pay within one year, such as accounts payable, short-term debt, taxes, and interest. The formula for the operating cash flow ratio is: Operating cash flow ratio = OCF / Current liabilities The operating cash flow ratio shows how many times a business can cover its current liabilities with its OCF. A higher ratio means that the business has more cash available to pay its short-term obligations, invest in growth opportunities, or distribute to shareholders. A lower ratio means that the business may struggle to meet its current liabilities, face liquidity problems, or rely on external financing.
There is no one-size-fits-all answer to what is a good operating cash flow ratio, as it may vary depending on the industry, the business cycle, and the company's strategy. Generally speaking, a ratio of 1 or above indicates that the business can pay its current liabilities with its OCF, which is a positive sign of liquidity and solvency. On the other hand, a ratio of 0.5 or below suggests that the business cannot pay its current liabilities with its OCF, which is a negative sign of liquidity and solvency. The business may need to sell assets, raise debt, or cut costs to improve its cash flow situation. A ratio between 0.5 and 1 indicates that the business can partially pay its current liabilities with its OCF, which is a neutral sign of liquidity and solvency. In this case, it is important to monitor cash flow closely and manage working capital efficiently.
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Seasonal changes may have a significant impact on the OCF ratio with respect to certain businesses whose sales, and resulting cash flow, are not static throughout the year or over a period of several years. The OCF ratio may trend lower at certain times as cash receipts decrease and higher as cash receipts increase. Calculating an OCF ratio during the low season may indicate a liquidity/solvency issue which will completely turn around during the high season. In these cases, it may be a better indicator to look at the OCF ratio as it trends over time to see a true indication of the company's liquidity.
There are several ways to improve the operating cash flow ratio, depending on the factors that affect the OCF and the current liabilities. For example, you can increase sales revenue and reduce operating expenses to boost OCF by improving the quality of products or services, expanding the customer base, raising prices, or lowering costs. You can also accelerate the collection of accounts receivable and delay the payment of accounts payable to increase OCF by offering discounts or incentives for early payments, enforcing strict credit policies, or negotiating better terms with suppliers. Additionally, reducing inventory levels and optimizing inventory turnover can help increase OCF by adopting lean production methods, forecasting demand accurately, or using just-in-time inventory systems. Finally, you can refinance short-term debt with long-term debt or equity to reduce current liabilities by securing lower interest rates, extending the maturity dates, or issuing new shares.
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Improving your Operating Cash Flow (OCF) ratio isn't solely for the finance team; it's a company-wide initiative. From CFO investment choices to warehouse supply orders, every decision can affect cash flow. To align the team, concentrate on key aspects like collecting payments quickly, efficient inventory turnover, and timely invoice settlement. By making cash flow a shared responsibility and setting clear metrics, you do more than bolster financial health. Even if your OCF ratio starts below the critical level of 1, the organisation can swiftly progress towards efficiency and success. This isn't just smart finance; it's smart business.
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For informational purposes only, improving operating cash flow from an inventory standpoint involves optimizing inventory turnover. Efficient inventory management, like just-in-time systems or ABC analysis, aids in reducing excess stock. Negotiating favorable payment terms with suppliers also helps manage cash outflows. Regularly evaluating demand patterns and adjusting inventory levels accordingly can enhance cash flow. However, this should be tailored to the specific business context for effectiveness and inclusive of seasonality.
The operating cash flow ratio can be employed for various purposes, such as comparing the cash flow performance of different businesses within the same industry or sector, evaluating a business' financial health and sustainability over time, and assessing the potential return on investment or dividend payout of a business. A higher ratio may signify a competitive advantage, a stronger market position, or a more efficient operation, as well as a higher capacity to reinvest in the business or reward the shareholders. Conversely, a declining or negative ratio may indicate a deteriorating or risky cash flow situation and a lower capacity to do so.
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I am not that inclined to use ratio between ocf and current liabilities as there are other stronger tools in the ratio analysis viz current ratio, quick asset which help understanding the liquidity position in a meaningful way and sales to EBIDTA for efficiency test. Cash flow should purely be used to test how strong is the interenal cash generation and how sustainable are the external cash flow reliances such as creditor, bank loans, etc.
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