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 = 46,407 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 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 = 65,824 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 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 = 46,407 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
- 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 = 46,407 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 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.
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.