Operating Cash Flow Ratio

Accountancy, is one of the most crucial disciplines of a business organization. Though the departments of accountancy, do not contribute directly to production and profit (well in most of the industries), they provide the entire industry with an invaluable service, that is, providing the company/firm with knowledge and information about the monetary worth of its activities. The past 100 years has seen widespread development of branches of accountancy. Initially it was just financial accountancy or book keeping for several centuries.

In recent past, concepts such as cost accounting, managerial accounting and analytical accountancy have come into being and have gained widespread acceptance. Modern accounting which is analytical and managerial in nature, aims at making a certain analysis and conclusion about the facts and figures of accountancy.

The principal tool of accounting analysis is ratios and percentages. Ratios and percentages give us an excellent idea about the financial position of the company/firm. Cash flow ratio is an extremely important aspect of the cash flow analysis.

A cash flow ratio depicts the relationship between the current liabilities of the firm and the total inward flow of cash, during a singular accounting year. The need and premise of this ratio can be explained as follows:

• In the modern business world, every company tends to have a certain set of liabilities, known as the current liabilities. These liabilities are chiefly the ones which expire within a year or in the near future. In short the company is obliged (legally) to pay off the said liabilities.

• Since the proceeds from the borrowed current liabilities contribute to the current production or provision of services, it is understood, or rather it is healthy and profitable for the business to recover the cost of current liabilities from current income.
• The operating cash establishes a ratio between the current income, also known as inward cash flow or cash flow arising from current operations and the current liabilities owed.

• The resultant figure depicts how much portion of the income is to be dedicated to paying off current liabilities. Inversely, it also depicts how much amount of income is owed to a current liability, or it also depicts how much portion of the liability is yet to be paid off from current income (the last one is applicable in case if the ratio is less than one). On the whole, a company or a firm's liquidity with respect to current income and liabilities is summarized within one ratio.

The formula and calculation for the operating cash flow ratio is quite simple and straightforward. The formula goes as:

Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities

In this formula, there are three very important things which are not included:

1. Non cash income, such as goods sold on credit goods, sold against a bill of exchange is not recorded as though minute and in some cases ridiculous, there is always a probability of a debtor defaulting upon such credit.

2. Long term liabilities such as a loan installment due, 2 years from date are also not included.
3. Any kind of differed, non cash, accrued income, income not relating to operations is not included in the formula.

The interpretation of the resultant of this formula is simple - it should be more than one. If it's less than one the current income and cash flow is not able to pay off the current liability and thus it is of essence to turn to other sources so as to pay off the liabilities.

Next off a figure less than one indicates a substantial loss incurred by the business. Lastly, the more the cash flow is exceeding one, the better is the financial position of the company and also the income rate and level.