What Is the Operating Cash Flow Margin?
Operating cash flow margin is a cash flow ratio that measures cash from operating activities as a percentage of total sales revenue in a given period.
Like operating margin, it is a trusted metric of a company’s profitability and efficiency and its earnings quality.
- The operating cash flow margin reveals how effectively a company converts sales to cash and is a good indicator of earnings quality.
- Operating cash flow margin is calculated by dividing operating cash flow by revenue.
- This ratio uses operating cash flow, which adds back non-cash expenses.
- This is what distinguishes it from operating margin, which uses operating income that excludes such expenses as depreciation.
Understanding the Operating Cash Flow Margin
Operating cash flow margin measures how efficiently a company converts sales into cash. It is a good indicator of earnings quality because it only includes transactions that involve the actual transfer of money.
Because cash flow is driven by revenues, overhead, and operating efficiency, it can be very telling, especially when comparing performance to competitors in the same industry. Has operating cash flow turned negative because the company is investing in its operations to make them even more profitable? Or does the company need an injection of outside capital to buy time to continue operating in a desperate attempt to turn around the business?
Just as companies can improve operating cash flow margin by using working capital more efficiently, they can also temporarily flatter operating cash flow margin by delaying the payment of accounts payable, chasing customers for payment, or running down inventory. But if a company’s operating cash flow margin is increasing from year to year, it indicates its free cash flow (FCF) is improving, as is its ability to expand its asset base and create long-term value for shareholders.
Operating Cash Flow Margin vs. Operating Margin
The operating cash flow margin is unlike the operating margin. The operating margin includes depreciation and amortization expenses. However, operating cash flow margin adds back non-cash expenses, such as depreciation.
Operating margin is calculated as operating income divided by revenue. This is similar to operating cash flow margin except it uses operating income. Operating cash flow margin uses operating cash flow and not operating income.
Free cash flow margin is another cash margin measure, where it also adds in capital expenditures. In capital-intensive industries, with a high ratio of fixed to variable costs, a small increase in sales can lead to a large increase in operating cash flows, thanks to operational leverage.
Operating Cash Flow Margin Example
Operating Cash Flow = Net Income + Non-cash Expenses (Depreciation and Amortization) + Change in Working Capital
Assuming company ABC recorded the following information for 2018 business activities:
- Sales = $5,000,000
- Depreciation = $100,000
- Amortization = $125,000
- Other Non-cash Expenses = $45,000
- Working Capital = $1,000,000
- Net Income = $2,000,000
And recorded the following information for 2019’s business activities:
- Sales = $5,300,000
- Depreciation = $110,000
- Amortization = $130,000
- Other Non-cash Expenses = $55,000
- Working Capital = $1,300,000
- Net Income = $2,100,000
We calculate the cash flow from operating activities for 2019 as:
- Cash Flow From Operating Activities = $2,100,000 + ($110,000 + $130,000 + $55,000) + ($1,300,000 - $1,000,000) = $2,695,000
To arrive at the operating cash flow margin, this number is divided by sales:
- Operating Cash Flow Margin = $2,695,000 / $5,300,000 = 50.8%
Frequently Asked Questions
How does operating cash flow margin differ from operating margin?
Operating cash flow margin includes non-cash charges like depreciation and amortization. This highlights a firm's ability to turn revenues into cash flows from operations,
What are cash flows from operations?
Also called cash flows from operating activities, or abbreviated as CFO, this figure represents the amount of money flowing through a company that is related to its core business activities.
Is it better to have higher or lower operating cash flow margin?
A higher ratio is always better, as it indicates that a greater proportion of revenues are being turned into cash flows.