Cash Flow from Operations Ratio

Definition

The term cash flow from operations ratio refers to a metric that allows the investor-analyst to understand if a company is depleting its cash reserves. The cash flow from operations ratio can use income from operations or net income.

Calculation

Cash Flow from Operations Ratio = (Net Income + Non-Cash Expenses - Non-Cash Sales) / Net Income

Where:

  • Net income is equal to sales revenues less all expenses, including depreciation, interest, and income taxes.
  • Non-cash expenses include those accounting expenses in the current reporting period that are not associated with the payment of cash. The most common example of a non-cash expense is depreciation.
  • Non-cash sales include items appearing on the income statement that do not affect its cash flow such as investment gains.

Explanation

Cash flow measures allow the investor-analyst to understand if the company is generating enough cash flow from ongoing operations to keep the company in a financially sound position over the long term. One of the ways to measure the ability of the company to generate enough cash from its core business operations is by calculating its cash flow from operations ratio.

Even when in compliance with Generally Accepted Accounting Principles (GAAP), a company can report what appears to be relatively robust income figures while depleting its cash reserves. One of the ways the investor-analyst can understand if a substantial amount of non-cash transactions is driving income results is by calculating the company's cash flow from operations ratio. By removing the effects of non-cash expenses and sales from net income and dividing that value by net income, the analyst can determine how these non-cash items are affecting net income. As the value of this metric approaches 1.0, the effects of non-cash items diminish. Generally, this ratio should be above 0.50.

Example

Company ABC's most recent annual report indicated net income of $3,000,000, non-cash expenses of $20,000 (primarily depreciation) and investment gains of $150,000. The company's cash flow from operations ratio would then be:

= ($3,000,000 + $20,000 - $150,000) / $3,000,000
= $2,870,000 / $3,000,000, or 0.95

In this example, 0.95, or 95% of net income is not affected by non-cash transactions.

Related Terms

operating leverage rationet income percentagecore operating earningscore growth rate