Cash Flow Ratio Analysis

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

  1. Cash flow to net income ratio
  2. Cash flow margin ratio
  3. 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 to net income = Cash flow from operating activities / Net income
  1. Cash flow from operating activities is shown in the cash flow statement of the business.
  2. Net income is shown in 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.

Income Statement
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
Cash Flow Statement
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

In the example above the cash flow from operating activities is 46,407 and the net income is 36,561. The cash flow ratio is calculated by using the formula as follows.

Cash flow from operating activities = 46,407
Net income = 36,561
Cash flow to net income ratio = Cash flow from operating activities / Net income
Cash flow to net income ratio = 46,407 / 36,561
Cash 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 Flow Ratio Example Using Apple Inc.

Similar calculations can be made using any published sets of financial information. For example using the financial statements of Apple Inc. for 2016 the cash flow ratio can be calculated as follows.

Cash flow from operating activities = 65,824
Net income = 45,687
Cash flow to net income ratio = Cash flow from operating activities / Net income
Cash flow to net income ratio = 65,824 / 45,687
Cash 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 ratio 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
  1. Cash flow from operating activities is shown in the cash flow statement of the business.
  2. Sales revenue is shown in the income statement.

There is no absolute correct value for the cash flow margin ratio. 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 Ratio 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 = 46,407
Sales = 200,000
Cash flow margin ratio = Cash flow from operating activities / Sales
Cash flow margin ratio = 46,407 / 200,000
Cash 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 = 65,824
Sales = 215,639
Cash flow margin ratio = Cash flow from operating activities / Sales
Cash flow margin ratio = 65,824 / 215,639
Cash 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
  1. Cash flow from operating activities is shown in the cash flow statement of the business.
  2. 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.

Balance sheet
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 cash flow ratio is calculated by using the formula as follows.

Cash flow from operating activities = 46,407
Total assets = 102,430
Asset efficiency ratio = Cash flow from operating activities / Total assets
Asset efficiency ratio = 46,407 / 102,430
Asset 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 cash flow ratio can be calculated as follows.

Cash flow from operating activities = 65,824
Total assets = 321,686
Asset efficiency ratio = Cash flow from operating activities / Total assets
Asset efficiency ratio = 65,824 / 321,686
Asset 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.

Cash Flow Ratio Analysis September 25th, 2017Team

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