What is Operating Cash Flow Ratio? Meaning, Examples, Advantages

Operating cash flow ratio is the ratio of cash flow from operations of a company to its current liabilities. If you ask experienced investors how they make profits in the stock market, they will tell you that they select stocks and invest after extensive fundamental analysis. Experienced investors commonly use a liquidity ratio called the operating cash flow ratio among numerous fundamental analysis ratios. The operating cash flow ratio calculates a company’s ability to pay off its current liabilities using its generated cash.

This article will help you understand the cash flow from operations ratio, commonly known as the operating cash flow ratio. You will learn about the operating cash flow formula and how to find operating cash flow.

What is Operating Cash Flow Ratio? 

Operating cash flow ratio is a liquidity ratio that measures a company’s ability to settle or pay off its current liabilities using the money it generates from its core business activities.

In financial terms, operating CF measures a company’s operating income per rupee, which is tied to its current liabilities. As company earnings may vary depending on current costs, operating CF is used by investors to evaluate a company’s short-term liquidity.

Two factors constitute the operating cash flow equation:

• Operating Cash Flow: Operating cash flow is the money a company generates at a specific time through its core business activities.
• Current Liabilities: These are short-term liabilities, such as accounts payables or loans, which the company must settle within a year.

Formula for the Operating Cash Flow 

The operating cash flow ratio formula is derived by dividing the cash flow generated by the company through its core activities, by its current liabilities.

Operating Cash Flow Direct Method and Indirect method:

In the direct method of calculating operating cash flows the cash payments made in the course of operations are subtracted from the cash receipts from the operations.

Operating cash flows can also be calculated through the indirect method. In the indirect method operating cash flows of the business are calculated from net income or net profit of the business.

Example of Operating Cash Flow in Business 

Here is a detailed cash flow from operating activities example for a better understanding of the operating cash flow ratio formula:

A company’s cash flow statement has the following entries:

• Net Income = Rs. 20 crore
• Depreciation & Amortisation (D&A) = Rs. 6 crore
• Increase in Net Working Capital (NWC) = (Rs. 2 crores)

The company’s balance sheet shows the following current liabilities:

• Accounts Payable = Rs. 4 crore
• Accrued Expenses = Rs. 3 crore
• Short-Term Debt = Rs. 2 crore

Now, calculating cash from operations:

This means the company’s operating cash flow can cover its short-term liabilities 2.67 times, indicating strong liquidity.

Importance of Operating Cash Flow in Financial Analysis

Investors evaluate a company’s current liquidity based on the results they get after calculating the operating cash flow ratio. It depicts how financially strong and liquid a company is and how easily it can pay off its current liabilities using the amount it generates from its core business activities.

If the operating cash flow ratio is higher than 1, it means that the company is adequately liquid and can pay off its current liabilities easily. On the other hand, if the operating cash flow ratio is lower than 1, the company is not generating enough cash flow to cover its current liabilities fully.

Advantages & Limitations of Operating Cash Flow 

Here are some advantages and limitations of operating cash flow:

Advantages of Operating Cash Flow

• Liquidity Indicator: Operating cash flow ratio assists investors in finding out the ability of a company to pay off its current liabilities without taking more loans.

• Less Manipulation: Operating cash flow ratio is a reliable tool as it does not use net income but operating cash flow for calculation. Net income is more prone to manipulation.

• Financial Health: An operating cash flow ratio higher than 1 indicates positive short term liquidity position of a company.

Limitations of Operating Cash Flow

• Capital Expenditure Exclusion: Operating cash flow ratio does not account for capital expenditures essential for a company’s long-term growth.

• Not a Viable Profitability Indicator: Operating cash flow ratio is not a viable profitability indicator. A company with a high OCF ratio may still be unprofitable due to high non-cash expenses.

• Volatility: Operating cash flow ratio may be volatile due to changing factors such as working capital, making it harder to calculate.

Operating Cash Flow Ratio vs Current Ratio

Here is a detailed table explaining the difference between operating cash flow ratio and the current ratio:

Conclusion 

Most companies rely on short-term debt, such as accounts payable, for their working capital requirement or some other short-term purposes. However, they must pay off the short-term debt within 12 months, making it important to generate enough cash from their core business operations to pay off their current liabilities easily.

The operating cash flow ratio calculates the cash generated from the core business activities and divides the amount with current liabilities. If the result is higher than 1, it depicts that the company has enough cash to cover its current liabilities without relying on external financing.