Cash Flow from Operations Ratio

Author:	Unknown
Used For:	Accounting, KPIs, Measuring Cash Flows

Overview

The Cash Flow from Operations Ratio is a method that helps to determine a company’s short term liquidity, or whether or not it is able to pay off its current liabilities. One may also say that the cash flow from operations ratio is a measure of the quality of a company’s earnings, because a company may be profitable yet still not be able to pay off its debts. It measures the extent to which a company’s cash flow differs from its reported operating income or net income. This measure is important because, under both US GAAP and IFRS, a company can easily report a healthy income, even while its actual cash reserves are very low.

Calculating Cash Flow from Operations Ratio

There are two methods for calculating this ratio:

Dividing the operational cash flow by income from operations – This gives a more accurate picture of the proportion of cash that is being impacted by ongoing operations
Dividing the entire transactional cash flow by net income – This shows the effect of transactions that have no relation to operations

Both of the above calculations measure the cash generated from operational activities, not taking into account capital spending or working capital requirements. See formula below:

Management Theories: Cash Flow From Operations

Please Note:

A difference in cash flow from operations ratio as compared with reported earnings indicates substantial non-cash expenses or sales within the reported earnings figures. Further, if a company reports record income but the operating cash flows are in the negative, then the company may be using very aggressive accounting techniques.
If the cash flow from operations ratio is significantly less than 1, or steadily decreasing over a long period, it means that the company has generated less cash during the year than what is needed to pay off its short term liabilities. This may signal the need to raise funds in order to meet liabilities.