Operating Cash Flow (OCF) Ratio: What It Is, Formula & Limitations

What is Operating Cash Flow Ratio?

The Operating Cash Flow (OCF) ratio of a business measures how quickly it can settle its current liabilities with cash flow from its core operations. This is a liquidity ratio and indicates a company’s operating income per rupee tied up in current liabilities. It must be noted that earnings can vary depending on accrued costs. That is why the operating cash flow ratio comes in handy when evaluating the near-term liquidity of the company.

Before moving forward let’s straighten out the two terminologies used above, operating cash flow and current liabilities, as they constitute the Operating Cash Flow Ratio:

1. Operating Cash Flow (OCF): OCF (also called Cash Flow from Operations or CFO) shows how much cash flow a company generates through its core business operations. This number is closely watched by investors and analysts as it is a great indicator of a company’s financial health. A negative OCF signals that business operations are not sustainable in the long term and it somehow needs to raise capital to remain solvent.

2. Current Liabilities: These are short-term obligations that have to be settled within a year, such as short-term debt and accounts payable.

Operating Cash Flow Ratio Formula

Now that we have understood the Operating Cash Flow Ratio meaning and the two key components of the Operating Cash Flow Ratio, let us check the Operating Cash Flow Ratio formula:

A higher Operating Cash Flow Ratio indicates that a company managed to garner high cash flow when it was required to service its short-term debts. In this formula, Operating Cash Flow is used because net earnings are easier to manipulate and OCF is considered a more sophisticated and cleaner indicator of near-term financial health.

Example of Operating Cash Flow Ratio

Let’s say that a company’s Cash Flow Statement has the following entries:

Net Income = ₹15 crore

D&A = ₹5 crore

Increase in NWC = (₹1 crore)

The Current Liabilities from its Balance Sheet are:

Accounts Payable = ₹3 crore

Accrued Expense = ₹2 crore

Short-Term Debt = ₹1 crore

The company’s cash from operations is ₹19 crore, while its total current liabilities amount to ₹6 crore.

Cash from Operations = ₹15 crore + ₹5 crore – ₹1 crore = ₹19 crore

Total Current Liabilities = ₹3 crore + ₹2 crore + ₹1 crore = ₹6 crore

This means that the company’s Operating Cash Flow can cover the short-term liabilities 3.17 times.

Operating Cash Flow Ratio Analysis

The Operating Cash Flow Ratio signifies how easily a company can pay off its current liabilities from its present operating cash flow. If the OCF Ratio is greater than 1, it means that the company’s operating cash flow is more than the required amount to service all short-term obligations. However, if the OCF Ratio is lesser than 1, the company has lesser cash than its debt and must somehow raise capital to fulfil this requirement.

One must note that a low Operating Cash Flow Ratio is not indicative of dwindling financial health. A lower OCF Ratio can also be due to the huge investment of a company in a new project which eats up the present cash flow but stands to reward significantly more in the long term.

Limitations of using Operating Cash Flow Ratio

There are a few concerns that come with the use of the Operating Cash Flow Ratio, such as:

1. Although not rampant as the manipulation of net income, it is possible to tamper with this ratio as well. Depreciation may be subtracted from revenue although it is not a cash outflow, but a simple revaluation of assets over time. However, some companies do this.
2. This ratio cannot be used as a sole indicator and must be coupled with other ratios when performing the financial analysis of a company.
3. Building on the previous point, a low Operating Cash Flow is not always bad. Some initiatives are with a long-term vision, and they guzzle capital in the short term. This does not change the fundamentals of the company.

Difference between Current Ratio and Operating Cash Flow Ratio

Let us quickly go through the aspects that differentiate Current Ratio from the Operating Cash Flow Ratio:

Conclusion

The Operating Cash Flow Ratio is useful financial metric as it throws light on a company’s liquidity position and determines whether the cash will suffice for paying off short-term debts. However it must be remembered that multiple indicators must be used before making investment decisions and OCF Ratio alone will not be enough.

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