What is a cash flow ratio? (2024)

FAQs

What is a cash flow ratio? ›

A cash flow ratio is a financial metric that provides insight into a business's ability to pay off its current debts with cash generated in the same period. Several cash flow ratios are used to uncover crucial information about business performance, and in this guide, we explore all of them in detail.

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.

In most industries, the example above would be a prime example of a good cash flow coverage ratio. Generally, businesses aim for a minimum of 1.5 to comfortably pay debt with operating cash flows.

There is no ideal figure, but a cash ratio is considered good if it is between 0.5 and 1. For example, a company with $200,000 in cash and cash equivalents, and $150,000 in liabilities, will have a 1.33 cash ratio.

Well, while there's no one-size-fits-all ratio that your business should be aiming for – mainly because there are significant variations between industries – a higher cash flow margin is usually better. A cash flow margin ratio of 60% is very good, indicating that Company A has a high level of profitability.

A healthy cash flow ratio is a higher ratio of cash inflows to cash outflows. There are various ratios to assess cash flow health, but one commonly used ratio is the operating cash flow ratio—cash flow from operations, divided by current liabilities.

As a starting point, a Free Cash Flow ratio above 1 is considered favorable for any company. This implies that the business is generating enough cash to more than cover its operating expenses and investments, a key indicator of financial health.

To have a healthy free cash flow, you want to have enough free cash on hand to be able to pay all of your company's bills and costs for a month, and the more you surpass that number, the better. Some investors and analysts believe that a good free cash flow for a SaaS company is anywhere from about 20% to 25%.

Here's the formula for calculating the operating cash flow ratio:Operating cash flow ratio = CFO / liabilitiesExample: A company has a CFO of $150,000 and current liabilities of $120,000 at the end of the second quarter. If you divide the company's CFO by its liabilities, its operating cash flow ratio is $1.25.

While a ratio of 1 is sufficient to cover interest expenses, it also means that there's not enough cash to pay other expenses. Business owners should aim for a ratio of 2 or above, which means that interest expenses can be covered two times over.

What is a good price cash flow ratio? ›

A good price-to-cash-flow ratio is any number below 10. Lower ratios show that a stock is undervalued when compared to its cash flows, meaning there is a better value in the stock.

Interpretation of the Cash Ratio

Although there is no ideal figure, a ratio of not lower than 0.5 to 1 is usually preferred. The cash ratio figure provides the most conservative insight into a company's liquidity since only cash and cash equivalents are taken into consideration.

Higher Cash Ratios indicate less credit and liquidity risk, but if a company's ratio is too high, it could indicate mismanagement or misallocated capital. As with the other Liquidity Ratios, context is king for understanding the Cash Ratio.

Furthermore, a profitability ratio might be good for one type of business and not for another. For example, according to Indeed, a good net profitability ratio for the retail or food industry would be between 0.5% and 3.5% (as these industries have high overhead costs), while other industries should aim between 10-20%.

One can conduct a basic cash flow analysis by examining the cash flow statement, determining whether there is net negative or positive cash flow, pinpointing how the outflows compare to inflows, and draw conclusions from that.

Operating Cash Flow Ratio Analysis

Generally, a ratio over 1 is considered to be desirable, while a ratio lower than that indicates strained financial standing of the firm.

A good price-to-cash-flow ratio is any number below 10. Lower ratios show that a stock is undervalued when compared to its cash flows, meaning there is a better value in the stock.

A ratio of 1 or higher is generally considered to be a good indicator of a company's financial health. However, it is also important to consider the industry and size of the company when interpreting the cash flow adequacy ratio.