The term cash flow reinvestment ratio refers to a metric that allows the investor-analyst to understand the level of cash flow the company reinvests in their business. If the calculated ratio is relatively high, it can mean the company's owners are committed to growing the business.
Cash Flow Reinvestment Ratio = Increase in Fixed Assets and Working Capital / Cash Flow (Adjusted for Dividends)
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 understand the commitment of a company to its business is to calculate their cash flow reinvestment ratio.
By calculating a company's cash flow reinvestment ratio, the investor-analyst can understand the proportion of its cash flow the company plows back into the business in the form of new investments. If the ratio is relatively high, it can signal this type of commitment; since a large portion of its cash flow is going to investment and not being returned to shareholders. However, it may also signal the company is having difficulties raising funds elsewhere.
To gain a better understanding of how the company is performing, this metric can be used as a benchmark, comparing the company to its industry peer group.
An investor is considering the purchase of Company ABC's common stock, but they would first like to gain a better understand of management's commitment to the business in terms of growth. Company ABC competes in the cloud industry, which is rapidly expanding. Given the industry, the analyst is hoping to find a ratio that is greater than 1.0, which indicates the company is not just investing all of their cash back into the business but also seeking additional monies to fund its growth.
Using Company ABC's most recent quarterly financial release, the analyst found fixed assets increased by $2,527,000, working capital increased by $1,750,000, net income was $3,023,000 non-cash expenses were $84,000, non-cash sales were $15,000 and the company paid no dividends.
Calculating the cash flow reinvestment ratio:
= ($2,527,000 + $1,750,000) / ($3,023,000 + $84,000 - $15,000)
= $4,277,000 / $3,092,000), or 1.38
Since the ratio found was in excess of 1.0, the investor analyst concluded Company ABC has the potential to compete in the cloud industry and began the process of evaluating other financial metrics before purchasing shares of stock.