Businesses use cash flow ratios to determine their overall financial performance. You can use different cash flow ratios to learn more about different aspects of business finance. Learning the various formulas and when to use them can be very helpful if you want to know more about a company’s ability to pay off debt. In this article, we explain what a cash flow ratio is, its type, and how to use it.
What is a Cash Flow Ratio?
Cash flow ratio or cash flow ratio is a mathematical equation used to determine the financial condition of a business. Cash flow ratios are very useful when trying to understand a company’s profits and losses.
Cash flow is money that is constantly coming in and out of a business. The more cash flow a company has, the less vulnerable it is to financial damage caused by an overall business downturn.
The Importance of Cash Flow Ratio
The cash flow ratio is very important for the financial analysis of a business. Each ratio reveals a certain financial aspect of the company. When using a cash flow ratio, a business knows how much money it has, where the money is going, and what needs to be done to maintain a balanced budget.
The cash flow ratio is simple, so you can easily add value and get results without the help of a financial professional. This ratio is also very reliable because you can use it at any time to get results for any period of time. For example, while balance sheets provide valuable data, they are not always up to date at the time you analyze them. You can use the cash flow ratio based on the latest financial data.
The cash flow ratio provides a business opportunity to identify certain types of financial problems and fix them. They also narrow down important information that business owners want to know, such as how much money they should invest or pay off debt while also considering the role of interest.
Types of Cash Flow Ratio
Businesses use several cash flow ratios to determine important pieces of financial information. Some ratios are used more often than others, depending on the business and what their needs are in terms of money analysis.
Consider the following common cash flow ratios used in financial analysis:
Current liability coverage ratio
The current liability coverage ratio calculates how much money a business has to pay off debt. This equation calculates the amount of money that must be paid in one fiscal year or in one operating cycle.
A business must have enough cash to pay off its obligations in full. If after calculating the ratio, the result is a number greater than one, it means the business has enough cash to pay off current liabilities.
Here is the formula for calculating the operating cash flow ratio:
Cash flow from operations / average current liabilities = operating cash flow ratio
Cash flow coverage ratio
The cash flow coverage ratio considers a business’s debt and whether their current cash flow is sufficient to pay it off. The resulting figure shows the number of times the business can pay the principal and interest with its current cash flow. It provides insight into the ability of the business to pay the amounts currently due.
Here is the formula for calculating the cash flow coverage ratio:
Cash flow from operations / total debt = cash flow coverage ratio
Price to cash flow ratio
The price to cash flow ratio considers the stock price of the business determined by the current stock price. The total price-to-cash-flow ratio is important because it reveals how valuable a business is at any given time
A lower price for cash flow is ideal, indicating that the value of the stock is likely to increase. It also means that even if the stock price is not high, the business can support itself with current cash flow.
Here is the formula for calculating the price to cash flow ratio :
Stock price/cash flow price per share = price to cash flow ratio
Interest coverage ratio
The interest coverage ratio looks at the business’s interest payments and how easily the business can pay its total debt and interest. A business should strive to have a number above one.
Here is the formula for calculating the interest coverage ratio:
Earnings before interest and tax /interest = interest coverage ratio
Operating cash flow ratio
This ratio calculates how much cash the business generates as a result of sales. The preferred operating cash flow figure is greater than one because it means the business is doing well and the company has enough cash to operate. Over time, the total cash flow ratio of the business should increase as it shows financial growth.
The following is the formula for calculating the operating cash flow ratio :
Cash flow from operations / liabilities = operating cash flow ratio
How to Calculate Cash Flow Ratio?
There are several ways to calculate the cash flow ratio. Here are the key steps for using a cash flow ratio:
1. Set which ratio you want to use
When calculating a cash flow ratio, you need certain financial information. It is useful to include the amount you need at the beginning of the calculation to save you time. It also helps you focus on one thing at a time rather than going from finding numbers to counting them. For the ratios listed in this article, you’ll need the following amounts:
- Cash flow from operations
- Total Amoun of debt
- Sale
- Current liabilities
- stock price
2. Create a math equation
The cash flow ratio requires minimal mathematical division. Create a cash flow equation by placing one amount over the other according to the ratio you want to use. Start by writing the official equation on a piece of paper for reference. Use these notes to add numbers to the calculator when you’re ready.
3. Count the amount
Use a calculator to add values and get results. You may be able to calculate the ratio on paper if the numbers are correct or you are using the average.
4. Confirm results
Be sure to calculate your cash flow ratio to verify your answer. You want to make sure your answers are accurate and reliable. If other coworkers are also using cash flow ratios for data collection, consider comparing results.
5. Save answers in data collection software
After calculating all the cash flow ratios you need, record the answers in your business data collection software. Some businesses use a spreadsheet to record this amount while others write it down manually.