Operating Cash Flow Ratio: Definition, Formula & Importance

What Is the Operating Cash Flow Ratio?

The operating cash flow ratio is a measure of a company’s ability to cover current liabilities with money generated from a company’s operations. This ratio can help gauge a company’s liquidity in the short term. Operating cash flow more accurately measures financial health than net income because net income figures can be altered more easily by accounting manipulation. The formula for the operating cash flow ratio is operating cash flow divided by current liabilities. A higher ratio indicates that a company has more cash than needed to pay off current liabilities.

How to Calculate the Operating Cash Flow Ratio

$\text{Operating cash flow ratio} = \frac {\text{Operating cash flow}}{\text{Current liabilities}}$Operating cash flow ratio=Current liabilitiesOperating cash flow​
The operating cash flow ratio is calculated by dividing operating cash flow by current liabilities. Operating cash flow is the cash from regular business activities.

Breaking Down Operating Cash Flow Ratio Components

A company deducts the cost of goods sold and operating expenses like attorney fees and utilities from its revenues. 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. 

Current liabilities are all liabilities due within one fiscal year (FY) or operating cycle, whichever is longer. They are found on the balance sheet and are typically regarded as liabilities due within one year.

Interpreting the Operating Cash Flow Ratio: What It Means for Your Business

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, greater than one, indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities.

An operating 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.

Many interpretations exist, and not all indicate poor financial health. A firm might temporarily harm cash flows with a project that yields future rewards.

Comparing the Operating Cash Flow Ratio and the Current Ratio

Both the operating cash flow ratio and the current ratio measure a company’s ability to pay short-term debts and obligations.

The operating cash flow ratio assumes cash flow from operations will be used to pay those current obligations (i.e., current liabilities). The current ratio, meanwhile, assumes current assets will be used.

Real-World Examples: Operating Cash Flow Ratio in Action

Consider two giants in the retail space, Walmart and Target. As of Feb. 27, 2019, the two had current liabilities of $77.5 billion and $17.6 billion, respectively. Over the trailing 12 months, Walmart had generated $27.8 billion in operating cash flow, while Target generated $6 billion.

The operating cash flow ratio for Walmart is 0.36, or $27.8 billion divided by $77.5 billion. Target’s operating cash flow ratio works out to 0.34, or $6 billion divided by $17.6 billion. The two had similar ratios, meaning they had similar liquidity. Digging deeper, we find that the two also shared similar current ratios as well, further validating that they indeed had similar liquidity profiles.

Understanding the Limitations of the Operating Cash Flow Ratio

Although not as prevalent as with net income, companies can manipulate operating cash flow ratios. Some companies deduct depreciation expenses from revenue even though it does not represent a real outflow of cash.

Depreciation expense is used to write off asset value over time. As a result, companies should add depreciation back to cash in cash flow from operations.

The Bottom Line

The operating cash flow (OCF) ratio is essential for assessing a company’s short-term liquidity. It shows how well a company can cover its current liabilities with cash from operations. A higher OCF ratio signifies strong liquidity, while a lower ratio might suggest the need for additional capital or an ongoing strategic project. Investors often prefer OCF for analyzing cash flow because it is less prone to manipulation compared to net income. Both the operating cash flow ratio and the current ratio serve to evaluate a company’s ability to meet its short-term debts. However, they rely on different assessments; the former uses cash flows, while the latter uses current assets. Understanding the limits of the OCF ratio, such as potential manipulation through non-cash expenses like depreciation, is crucial for accurate financial analysis.