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What is 'Operating Cash Flow Ratio'

The operating cash flow ratio is a measure of how well current liabilities are covered by the cash flows generated from a company's operations. The operating cash flow ratio can gauge a company's liquidity in the short term. Using cash flow as opposed to income is considered a cleaner, or more accurate, measure since earnings can be manipulated.

BREAKING DOWN 'Operating Cash Flow Ratio'

There are essentially two dimensions of fundamental investment analysis: one based on cash and the other based on earnings. Good fundamental analysts consider both when researching the value of an investment.  

Cash Flow From Operations

A company generates revenues, and from revenues deducts the cost of goods sold and other associated operating expenses, such as attorney fees and utilities.  Cash flow from operations is the cash equivalent of net income.  It is the cash flow after operating expenses have been deducted and before the commencement of new investments or financing activities.  Investors tend to prefer reviewing the cash flow from operations over net income because there is less room to manipulate results.  However, together, cash flows from operations and net income can provide a good indication of the quality of a firm's earnings.  

Calculation and Interpretation

The operating cash flow ratio is calculated by dividing cash flows from operations by current liabilities. Current liabilities are all liabilities due within one fiscal year or operating cycle, whichever is longer.  They are found on the balance sheet and are typically regarded as liabilities due within one year.  The operating 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 (>1) indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities. A ratio 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, and not all are indications of poor financial health.  For example, a firm may embark on a project that compromises cash flows temporarily but renders great reward in the future.  

Ratio Manipulation

Although not as prevalent as with net income, companies can manipulate operation cash flow ratios. Some companies deduct depreciation expenses from revenue even though it does not represent a real outflow of cash. Depreciation expense is an accounting convention that is meant to write off the value of assets over time. As a result, companies add depreciation back to cash in cash flow from operations.

Another way companies can manipulate cash flow is by extending the time to pay bills. If companies pay bills later, they can extend payables and maintain their cash balance. Similarly, firms can reduce the amount of time it takes to collect on their accounts receivable, thus increasing cash.

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