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Monday, 17 June 2013

Cash Flow Ratios

The Cash Flow Ratios look at how much cash is being generated and the safety net that it provides to a company. The three most commonly used Cash Flow Ratios are examined below:

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

1) Operating Cash Flow / Sales Ratio

The Operating Cash Flow to Sales Ratio compares a company's operating cash flow to its net sales or revenues, it gives the analysts and investors indications about the ability of a company to generate cash from its sales. In other words, it shows the ability of a company to turn its sales into cash. It is expressed as a percentage. Positive and negative changes in a company's terms of sale and/or the collection experience of its accounts receivable will show up in this indicator.

Formula : Operating Cash Flow / Sales Ratio = Operating Cash Flow / Sales (Revenue) 

Benchmark : There is no standard guideline for the operating cash flow/sales ratio, a comparison against previous years ratios provides an indication on whether a company has a positive or negative trend in this ratio. A consistent and/or increasing trend in this ratio is a positive indication of good debtor’s management. Companies with such a trend in this ratio are good investment opportunities.

Note : Ideally there should be a parallel increase in operating cash flows with the increase in sales. If the cash flows do not increase with the increase in sales it may be a result of either a change in terms of sales or inefficient / ineffective management of trade receivables

Calculation : The Operating Cash Flow / Sales Ratio for Cisco as at 28 Jul 2012 is 11,491 / 46,061 = 24.95%.

2) Free Cash Flow / Operating Cash Flow Ratio

The Free Cash Flow/ Operating Cash Flow Ratio measures the relationship between free cash flow and operating cash flow of a company. The more free cash flows are embedded in the operating cash flows of a company, the greater the financial strength of the company. Free cash flow is considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency. A company can use the free cash flow for expansion, acquisitions, and/or financial stability to weather difficult market conditions.

Formula : Free Cash Flow / Operating Cash Flow Ratio = Free Cash Flow / Operating Cash Flow
Where Free Cash Flow = Operating Cash Flow - Capital Expenditure - Dividends Paid

Benchmark : There is no standard guideline for this ratio. Higher free cash flows to operating cash flows ratio is desired as it is a indication of financial strength of a company.

Note : The concept of free cash flows is becoming more and more popular among investors. Institutional investment firms rank free cash flow ahead of earnings as the single most important financial metric used to measure the investment quality of a company.

Calculation : The Free Cash Flow / Operating Cash Flow Ratio for Cisco as at 28 Jul 2012 is 8,864 / 11,491 = 77.14%.

3) Dividend Payout Ratio

Dividend Payout Ratio measures the fraction of net income a company pays to its shareholders in dividends, it provides an idea of how well earnings support the dividend payments. Investors seeking high current income and limited capital growth prefer companies with high Dividend payout ratio. However investors seeking capital growth may prefer lower payout ratio because capital gains are taxed at a lower rate. High growth firms in early life generally have low or zero payout ratios. As they mature, they tend to return more of the earnings back to investors. 

Investors like to see consistent and/or gradually increasing dividend payout ratio. A stable dividend payout ratio indicates a solid dividend policy by the company's board of directors while a reduction in dividends payout is looked poorly upon by investors and the stock price most likely will take a hit. 

Formula : Dividend Payout Ratio = Dividends per Share / Earnings per share

Benchmark : This ratio need to be compared against the company's historical payout or to against dividend payout to its peers'.

Note : Investors need to remember that dividends actually get pad with cash and not earnings. A company with an adequate unrestricted balance in retained earnings will not be able to pay cash dividends if it has inadequate cash. Investor need to check a company's payout ratio against an adequate margin of free cash flow to ensure the sustainability of the payout ratio.

Calculation : The Dividend Payout Ratio for Cisco as at 28 Jul 2012 is (1,501/5,340) / (8,041/5,340) = 18.67%.

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