In many cases, cash flow ratios signify a more accurate measurement of a stock’s value than the price to earnings ratio, P/E. Cash flow ratios examine the flow of money into a company, it can help to identify struggling companies and in turn, struggling stocks. Price to earnings is a very important ratio because when is very high or low, it usually makes a splash on the financial pages. Price to earnings ratio is valuable metric and can help a successful investor with his or her stock technical analysis, but it is only one technical analysis tool and should be considered as such. While the same can be said for each of the cash flow ratios, these give insight into the money coming in and going out of a company. A company can demonstrate earnings, but if more money is pouring out a company than pouring in, there will fiscal problems in the future.
Profits are very vital for the survival of a company. But sometimes, companies look like very profitable may actually opposite what you seen. It might encounter financial risk if they are generating little cash from these profits. For example, a company can look profitable if they sales on credit and have not received cash for the sales that hurt their financial health since they obliged to pay. Cash flow ratios use cash flow compared to other company metrics. They are used to determine amount of cash generated from their sales or free and clear, and the how much cash they have to cover obligations. The ratio that will be looked at are operating cash flow/sales ratio, free cash flow/operating cash flow ratio and cash flow coverage ratios.
Operating Cash Flow/Sales Ratio is expressed as a percentage, compares a company’s operating cash flow to its net sales or revenues. This ratio gives investors an idea of the company’s ability to turn sales into cash. It would be worrisome to see a company’s sales grow without a parallel growth in operating cash flow. This indicator will show the changes in a company’s terms of sale or the collection experience of its accounts receivable whether in positive or negative. In this ratio, we use the figure for operating cash flow that frequently named in financial reporting as cash flow from operating activities, simply cash flow, net cash provided by operating activities and cash flow provided by operations.
In the operating section of the cash flow statement, the net income figure is adjusted for non-cash charges and increases/decreases in the working capital items in a company’s current assets and liabilities. This reconciliation results in an operating cash flow figure, the foremost source of a company’s cash generation. The greater the amount of operating cash flow, the better. There is no standard guideline for the operating cash flow/sales ratio, but obviously, the ability to generate consistent or improving percentage comparisons are positive investment qualities.
The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow. Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company’s competitiveness and efficiency. The cash flow remaining after this deduction is considered “free” cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company’s operating cash flow, the greater the financial strength of the company.
Cash flow coverage ratios measures the ability of the company’s operating cash flow to meet its obligations – including its liabilities or ongoing concern costs. The operating cash flow is simply the amount of cash generated by the company from its main operations, which are used to keep the business funded. The larger the operating cash flow coverage for these items, the greater the company’s ability to meet its obligations, along with giving the company more cash flow to expand its business, withstand hard times, and not be burdened by debt servicing and the restrictions typically included in credit agreements.
Dividend payout ratio identifies the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment. Here’s how dividends “start” and “end.” During a fiscal year quarter, a company’s board of directors declares a dividend. This event triggers the posting of a current liability for “dividends payable.” At the end of the quarter, net income is credited to a company’s retained earnings, and assuming there’s sufficient cash on hand and/or from current operating cash flow, the dividend is paid out. This reduces cash, and the dividends payable liability is eliminated. The payment of a cash dividend is recorded in the statement of cash flows under the “financing activities” section.
Other ratio is such as operating cash flow ratio is one of the most important cash flow ratios. Cash flow is an indication of how money moves into and out of the company and how you pay your bills. Operating cash flow relates to cash flows that a company accrues from operations to its current debt. It measures how liquidity a firm is in the short run since it relates to current debt and cash flows from operations.
Operating Cash Flows Ratio = Cash Flows From Operations/Current Liabilities
Where, Cash flows from operations comes off the Statement of Cash Flows and Current Liabilities comes off the Balance Sheet. If the Operating Cash Flow Ratio for a company is less than 1.0, the company is not generating enough cash to pay off its short-term debt which is a serious situation. It is possible that the firm may not be able to continue to operate.
The price to cash flow ratio is often considered a better indication of a company’s value than the price to earnings ratio. It is a really useful ratio for a company to know, particularly if the company is publicly traded. It compares the company’s share price to the cash flow the company generates on a per share basis.
Price/cash flow ratio = Share price/Operating cash flow per share
Where, Share price is usually the closing price of the stock on a particular day and operating cash flow is taken from the Statement of Cash Flows. Some business owners use free cash flow in the denominator instead of operating cash flow. It should be noted that most analysts still use price/earnings ratio in valuation analysis.
The Cash Flow Margin ratio is an important ratio as it expresses the relationship between cash generated from operations and sales. The company needs cash to pay dividends, suppliers, service debt, and invest in new capital assets, so cash is just as important as profit to a business firm. The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The calculation is:
Cash Flow Margin ratio (%) = Cash flow from operating cash flows/Net sales
The numerator of the equation comes from the firm’s Statement of Cash Flows. The denominator comes from the Income Statement. The larger the percentage, the better.
Cash flow from Operations/Average total liabilities is a similar ratio to the commonly-used total debt/total assets ratio. Both measure the solvency of a company or its ability to pay its debts and keep its head above water. The former is better, however, as it measures this ability over a period of time rather than at a point in time. This ratio is calculated as follows:
Cash flow from Operations/Average Total Liabilities = _______%
Where, Cash flow from operations is taken from the Statement of Cash Flows and average total liabilities is an average of total liabilities from several time periods of liabilities taken from balance sheets. The higher the ratio, the better the firm’s financial flexibility and its ability to pay its debts.
The current ratio is the most simple of the cash flow ratios. It tells the business owner if current assets are sufficient to meet current debt. The ratio is calculated as follows:
Current Ratio = Current Assets/Current Liabilities
Where, both terms come from the company’s balance sheet. The answer shows how many times over a company can meet its short-term debt and is a measure of the firm’s liquidity.
The quick ratio, or acid test, is a more specific test of liquidity than the current ratio. It takes inventory out of the equation and measures the firm’s liquidity if it doesn’t have inventory to sell to meet its short-term debt obligations. If the quick ratio is less than 1.0 times, then it has to sell inventory to meet short-term debt, which is not a good position for the firm to be in.
Quick Ratio = Current Assets – Inventory/Current Liabilities
Where all terms are taken off the firm’s balance sheet.