How to Calculate Cash Flow Ratios

Introduction

Cash flow ratios provide valuable insights into the financial position and profitability of a company. Knowing how to accurately calculate and use cash flow ratios can help you make better decisions related to your investments, lending, and cash management policies.

Cash flow ratios measure the short-term liquidity of a company, also known as its ability to meet short-term debts and obligations. It does this by analyzing the money coming in and out of the business over a set period of time. Knowing cash flow ratios gives you an in-depth understanding of a company’s financial health.

In this post, you will learn what cash flow ratios are, the benefits of using cash flow ratios, and how to calculate cash flow ratios.

Definition of Cash Flow Statements

Cash flow statements show the inflow and outflow of cash during a given period. Cash flow statements consist of three components: operating cash flow (OCF), investing cash flow (ICF), and financing cash flow (FCF).

Operating Cash Flow (OCF)

Operating cash flow is the cash a company generates from its primary operations or activities. It is calculated by deducting cash outflows from cash inflows. Operating cash flow does not include non-operating activities, such as interest or dividend payments.

Investing Cash Flow (ICF)

Investing cash flow includes cash used to purchase or sell investments, such as land, equipment, and marketable securities. It is calculated by subtracting cash outflows from cash inflows related to investments.

Financing Cash Flow (FCF)

Financing cash flow reflects all cash coming in or going out from debt and equity financing. It is calculated by subtracting cash outflows from cash inflows related to financing.

• Financing outflows are the payments made to creditors and equity holders.
• Financing inflows represent proceeds from debt and equity.

How to Calculate Cash Flow Ratios

Cash Flow to Total Asset Ratio

The cash flow to total asset ratio measures the overall liquidity of a company. This is computed by dividing cash flow from operations by the company's total assets. A lower ratio implies greater liquidity, while a higher ratio implies the opposite.

To calculate the cash flow to total asset ratio, take the cash flow from operations for a specific period and divide by the total assets for the same period. For example, if a company's cash flow from operations was $100 million and its total assets were $500 million, the cash flow to total asset ratio would be 0.2.

Cash Flow to Total Debt Ratio

The cash flow to total debt ratio is similar to the cash flow to total asset ratio, except that it measures the company's ability to cover its debt obligations with cash flow. This is computed by dividing cash flow from operations by the company's total debt obligations. A higher ratio implies greater stability, while a lower ratio implies the opposite.

To calculate the cash flow to total debt ratio, take the cash flow from operations for a specific period and divide by the company's total debt obligations for the same period. For example, if a company's cash flow from operations was $100 million and its total debt obligations were $500 million, the cash flow to total debt ratio would be 0.2.

Free Cash Flow

Free cash flow is a measure of a company's cash flow from operations after deducting any capital expenditures or other discretionary spending from that total. This measure is important as it allows investors to determine the amount of cash available for company operations, debt repayment or reinvestment.

To calculate free cash flow, take the cash flow from operations for a specific period and subtract any capital expenditures or other discretionary spending for that same period. For example, if a company's cash flow from operations was $100 million and its capital expenditures were $50 million, the free cash flow would be $50 million.

Cash Flow to Total Asset Ratio

The Cash Flow to Total Asset ratio is an important tool in understanding how effectively an organization is able to use its assets to generate cash flow. This ratio helps in pinpointing when an organization’s assets are not productive enough for its operations, and it can play a crucial role in helping managers and entrepreneurs make decisions about whether to invest additional resources into the organization. In this article, we will discuss the formula for this important ratio, as well as analysing results and what it means for businesses.

Formula

The Cash Flow to Total Asset ratio formula is simple, and can be quickly calculated from data available from an organization's financial statements. The formula is:

Cash Flow to Total Asset Ratio = Cash Flow / Total Assets

The cash flow in this instance is taken from the statement of cash flows. The total assets are taken from the organization's balance sheet.

Analysing the Results

When analyzing the results of a Cash Flow to Total Asset ratio it is important to look at how the ratio has changed over time. Ideally, the ratio should increase over time, meaning the organization is becoming more effective in generating cash flow from each of its investments. If the ratio is decreasing, instead, then it is a warning sign that the organization may not be using its resources as effectively as before. Additionally, it can also be useful to compare the organization’s Cash Flow to Total Asset ratio with the ratios of its competitors and other organizations in its sector as a benchmark.

A higher Cash Flow to Total Asset ratio is always better, as it implies that the organization is generating more return on its investments. The exact figure that represents a good ratio varies from industry to industry, however, so it is important to take those factors into account when analyzing results.

Cash Flow to Total Debt Ratio

The cash flow to total debt ratio is a useful indicator to measure an organization’s ability to pay off its obligations and liabilities. To calculate the cash flow to total debt ratio, companies must use the following formula:

Formula

Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt

Analysing the Results

The higher the cash flow to total debt ratio, the better as it indicates a company’s ability to make payments and cover its debt obligations. A ratio of over 1 indicates that there are sufficient funds to pay off all liabilities, whereas a ratio of less than 1 indicates the company has difficulty paying off its liabilities. It is important to note that a ratio of 1 or higher does not guarantee successful debt repayment as it only shows the adequacy of resources to do so.

Analyzing the cash flow to total debt ratio along with other financial ratios can help businesses identify issues with their business operations and take corrective action to improve financial health. For example, a ratio of less than 1 may indicate a need to review business operations to increase cash flow or reduce current liabilities.

Free Cash Flow

Free cash flow is the amount of cash remaining to the company after it has made all necessary expenditures, such as salary payments, debts, and taxes. It is an important measure of the company’s financial strength, as it is the amount of money available to pay dividends, fund mergers and acquisitions, buy back stock, or simply invest in the company's future.

Formula

The formula for calculating the free cash flow (FCF) of a business is:

• FCF = Cash from Operating Activities (CFO) - Capital Expenditures (CAPEX)

Analysing the Results

Once the FCF formula is applied and the results are obtained, company managers should analyze these results for an accurate understanding of their company’s overall financial position. Business owners should examine the trend in FCF. Increasing FCF indicates that the company is becoming more profitable, while decreasing FCF might be a sign that the company is struggling.

Free cash flow is a powerful tool in evaluating a company’s financial health. By understanding how to calculate and analyze free cash flow, company managers can make important decisions regarding the future of their business.

Conclusion

Cash flow ratios are important metrics to measure the financial performance of a business. By understanding cash flow ratios and properly calculating each of the five listed ratios, an investor can make informed decisions about their investments.

Summary of Calculations

Cash flow ratios can be calculated by dividing the relevant cash flows from operations by different metrics from a company's income statement, balance sheet, and/or cash flow statement. Cash flow ratios can also be calculated using various combinations of these financial statements.

Summary of Benefits

By performing cash flow ratio analysis, investors can identify areas of improvement within a business or better understand a company's strategic position. Additionally, by considering a group of companies, investors can gain insight into the overall health of an industry.