If you’re running a business, make sure you’re analyzing your business health regularly. This lets you know how your business is doing and whether or not to adjust any strategies. Liquidity is one of the four areas of financial health along with solvency, profitability, and operating efficiency. Liquidity refers to how easily your business’ assets can be converted into cash.
But do you know how to calculate the liquidity of your business? It’s not complicated at all because all you need is the right tool. Today, we’ll introduce you to the operating cash flow ratio, a metric to gauge your company’s liquidity.
What is the operating cash flow ratio?
Operating cash flow ratio measures how well a business can pay off its current liabilities with the cash flow generated from its core business operations. As earnings can be manipulated by managing assets, this ratio is considered a more accurate measure of a company’s liquidity in the short term.
Because operating cash flow is related to the ability to pay off liabilities (debts and financial obligations of a business), the higher ratio, the better. A high number indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities. On the other hand, a low number points out that there isn’t enough cash to cover its current liabilities. Therefore investors and analysts will have to call for more capital.
Operating cash flow ratio equation
Understanding operating cash flow ratio components
Before we learn about the operating cash flow ratio formula, let’s have a quick tour of its components.
Current liabilities or short-term liabilities are debts that must be paid within a year and can be found on the balance sheet. These include:
- Supplier payments
- Short-term debt payments such as loans to the bank or credit union
- Dividend payments to investors
- Taxes charges
It’s an obligation of every business to pay off its current liabilities. To do so, set current liabilities against current assets. It’s a good sign if they balance each other. It’s even greater if your business’s current assets are more than enough to cover your current liabilities. On the other hand, if your business doesn’t have enough assets to make up for short-term liabilities, you could face financial trouble.
Operating cash flow
Operating cash flow reports inflows and outflows as a result of regular operating activities. It includes the money your company gains from ongoing activities, such as manufacturing and selling goods or providing a service to customers. However, it doesn’t cover any other funds within the business, such as capital expenditures or investments.
Operating cash flow is calculated by deducting the business operating expenses from the total sales revenue. It shows business owners and operators the big picture concerning their business’ money flow, where funds are coming from, and going to.
By looking at the cash flow from operating activities, you can determine the financial success of your business’s core activities. As a result, it greatly impacts the company’s liquidity. It allows you to plan out how to generate and maintain sufficient cash necessary for operational efficiency and other necessary needs.
Now that we know about two components associated with the operating cash flow ratio, it’s time to learn the equation.
Operating Cash Flow Ratio = Operating cash flow / Current Liabilities
As you can see, there’s nothing complex here, simply divide cash flow from operations by current liabilities, and you’ll have an answer.
However, the preciseness of the equation lies in the accuracy of the numbers input. To make sure there’s no error in the amount of operating cash flow and current liabilities, your bookkeeper or accountant needs to keep and record all the payment receipts and sales proposals accordingly.
Isn’t it frustrating to go through that process manually when you’re living in the technological era? To be honest, there’s no benefit of doing things that way anymore because it takes up a lot of time. As a result, you’ll have to pay the price of working extra hours to cover other tasks that you don’t have enough time to finish.
You can see it coming, aren’t you? No worries, you still have a chance to turn the table around by reaching for the help of a digital tool. A digital tool allows you to scan your paper into data, get them organized, and make a report easily. Shoeboxed can help you do all these things within an hour instead of days. Check out Shoeboxed now and find out how much time you could save!
Example of the operating cash flow ratio
Imagine that Company A has a net cash flow from operations of $500,000 and a current liabilities of $120,000. Apply the formula and you’ll have:
500,000 / 120,000 = 4.17
This means that Company A earns $4.17 from operating activities per every $1 of current liabilities. Alternatively, it can be viewed as, “Company A can cover its current liabilities 4.17x over.”
The bottom line
Operating cash flow ratio provides you with a snapshot of your regular operating activities. By looking at this number, you can determine how sufficient your business is doing. Additionally, accessing the operating cash flow ratio to know your ability to pay off liabilities in a given period will keep your business out of trouble from financial litigation.