Overview:
The Operating Cash Flow (OCF) Ratio is one of the most important financial ratios which determine the ability of a company to continue meeting its operating obligations with more cash from operation.
 It offers information on the solvency and efficiency of an organization with regard to its ability to generate enough of it to discharge its obligations without resorting to use of external finance or selling of assets.
Definition of Operating Cash Flow
Operating cash flow refers to that earlier stated as the amount of cash generated from operating activities during a given period less the amount of cash spent on operating activities during the same period.Â
Why the Operating Cash Flow Ratio Matters?
The OCF Ratio is preferred for the analysis of the financial state of a business since CF is less amendable to manipulations as compared to net income.Â
It shows whether core activities of a business venture generate enough cash within themselves or whether cash from other sources are essential to continue running the venture.
Analysis of Operating Cash Flow Ratio
- Liquidity Assessment: Assist in establishing a company’s solvency ratio pertaining to the ability to pay the short-term liabilities using the revenue from operations.
- Creditworthiness Evaluation: Employees use the ratio to determine the organization’s financial stability before making borrowings and business investment.
- Comparison Across Companies: Allows for more accurate comparison of for cash flow efficiency between business within the same sector/regulation.
- Operational Efficiency: Gives a clue into how well a firm manages to bring out its operating cash flow.
The formula to calculate the Operating Cash Flow RatioÂ
Operating cash flow ratio = operating cash flow / current liabilities
Where:
- OF is valid for cash receipts from the activities of producing and delivering goods and services. This cash flow statement is a rough estimate of the operating cash flow.
- Comprises short term payables that includes the accounts payable, the short-term borrowings, other obligations that are payable in less than a year.
Step-by-Step Calculation
Take a step-by-step procedure for the calculation of the Operating Cash Flow Ratio:
- Obtain Operating Cash Flow: Take this from the cash flow statement of the company.
- Locate Current Liabilities: Obtain this amount from the firm’s balance sheet.
- Use the Formula: Determine the operating cash flow to current liabilities ratio
- Interpretation of the Result: Ratio greater than 1 suggests that the company generates enough cash from its operation that it is well-equipped to cover its short-term obligations.
Example Calculation
Consider the following scenario:
- Operating Cash Flow: $500,000
- Current Liabilities: $350,000
- Operating Cash Flow Ratio = Operating Cash Flow / Total Operating Expenditure = $500,000 / $350,000 = 1.43
InterpretationÂ
A total ratio of 1.43 means that the company has $1.43 easily earnable per $1 of current liabilities, and as a result, the company enjoys good liquidity.
Uses of the Operating Cash Flow Ratio
- Financial Planning: Facilitates in discovering the directions in cash flow and in determining potential requirements to support operations in the future.
- Debt Management: Helps in establishing the company’s ability to meet current obligations without this form of external help.
- Investment Analysis: Analysts and investors apply the ratio in order to compare the overall solvency and performance of a business entity.
- Risk Assessment: Looks at probable liquidity problems that probably would originate through operational or other undesirable conditions.
Flaws of the Operating Cash Flow Ratio
- Industry Variations: It may not be valid for comparisons between industries with different cash flows patterns/ their cycles.
- Seasonal Fluctuations: Some business may record off-balance ratios depending on the season in which they are established.
- Exclusion of Non-Operational Cash Flows: The intensity does not include cash flows from financing and investment activities; thus, it might distort the picture of the firm’s liquidity.
- Dependence on Historical Data: Cash flows from the past may not be a good indicator of future liquidity.
Applications of Operating Cash Flow Ratio
- Analyze Trends: Looking at the ratio over different periods, trends will be established.
- Combine with Other Metrics: It is recommended to be used together with the current ratio and the quick ratio for a reliable analysis.
- Contextual Interpretation: This should be done while bearing in mind the industry trend and the current economic situation.
- Regular Monitoring: Regular evaluation helps to avoid shortage of cash in the short term on time.
Conclusion
Operating cash flow ratio is a very useful liquidity and financial ratio, allow for sound organizational assessment.Â
Beneficial in that it paints a clear picture of a business entity’s prowess in the management of cash flow as against a firm’s accounting profits.Â
That having been said, it is recommended to be employed in combination with other financial indicators in order to carry out a comprehensive analysis of the company’s results.
Frequently Asked Questions
1.What is a desirable Operating Cash Flow Ratio?
Ideally the value of ratio should be 1.0 or higher to point that the cash generated by the company is more than sufficient to meet its obligations.
2. What effects does a low Operating Cash Flow Ratio have on a company?
Its low level indicates the problems with company’s liquidity which leads to higher dependence on external funds and higher default risk.
3. Is it possible that Operating Cash Flow Ratio is a problem?
This ratio reveals good solvency when its value is high but when the ratios are too high this means that resources are not fully utilized or financial policies are too cautious.
4. Should Operating Cash Flow Ratio be used in all industries?
Yes, but it is especially important in the industries which are capital intensive but where the availability of funds or working capital is vital.
5. Operating Cash Flow Ratio vs Current Ratio?
The Current Ratio type take into consideration all current assets, while the OCF Ratio only pay attention to Cash flow from operation.