What is a Cash Flow Ratio?
A cash flow ratio is a measure of the number of times a company can pay off current debts with cash generated within the same period. A high number, greater than one, indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities.
A cash flow ratio of less than one indicates the opposite—the firm has not generated enough cash to cover its current liabilities. To investors and analysts, a low ratio could mean that the firm needs more capital.
However, there could be many interpretations, not all of which point to poor financial health. For example, a firm may embark on a project that compromises cash flows temporarily but renders substantial rewards in the future.
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What are the different types of Cash Flow Ratios?
Cash flow ratios make a comparison between cash flows and other elements of a financial statement. The larger the amount of cash flow, the better ability the company will have to protect itself in the event of a temporary decline in performance, as well as the ability to pay dividends to investors.
Cash flow ratios are essential in understanding the liquidity of a business. They are especially important when evaluating the companies whose overall cash flow varies significantly from their reported profits.
Some of the most popular cash flow ratios are:
1. Cash flow margin ratio
Calculated as cash flow from operations divided by sales. Cash flow margin ratio is a more reliable metric than net profit, as it gives a much clearer picture of the amount of cash generated per pound of sales.
2. Cash flow to net income
If your cash flow to net income ratio is close to to 1:1, this indicates that your organisation is not engaging in any accounting intended to inflate earnings above cash flows.
3. Cash flow coverage ratio
Ideally this ratio will be as high as possible - calculated as operating cash flow divided by total debt. A high cash flow coverage ratio indicates that your company has sufficient cash flow to pay for any debt as well as the interest payments on that debt.
4. Price to cash flow ratio
Share price divided by the operating cash flow per share. This ratio is qualitatively stronger than the price/earnings ratio, since it uses cash flows instead of reported earnings, which is more difficult for a company to falsify.
5. Current liability coverage ratio
Cash flow from operations divided by current liabilities. With a current liability ratio of less than 1:1, a business is not generating enough cash to pay for its immediate obligations, which is potentially a sign of upcoming bankruptcy.
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