Cash Flow to Revenue Ratio
Financial ratios express relationships between revenue, profits and other financial-statement items. Management and investors can use ratios to evaluate a company's performance over time and against the industry. The cash flow-to-revenue ratio, also known as the operating cash flow-to-sales ratio or the cash flow-to-sales ratio, is the ratio of operating cash flow to revenue. It indicates management's ability to turn revenue into profits and net cash flow.
The formula for the ratio is operating cash flow divided by revenue, expressed as a percentage. Operating cash flow is net income plus adjustments for noncash items, such as depreciation expense, and changes in working capital, which is the difference between current assets and current liabilities. Depreciation is the allocation of a fixed asset's costs over its useful life. Current assets include cash, inventory and accounts receivable, which include items purchased on credit. Current liabilities include accounts payable, salaries payable and other short-term liabilities.
Management, investors and other stakeholders can use the cash flow-to-revenue ratio to evaluate the effectiveness of internal cost controls. A high ratio usually means the company is able to turn a higher percentage of its revenue into profits and net cash flow. A flat or increasing trend line is generally an indication of consistent sales growth and effective expense management. Poor receivables collection and higher expenses are some of the reasons for a declining trend line.
Operating cash flow depends on net income, which is revenue minus expenses. Therefore, if a company generates higher revenue, it must keep expenses steady relative to revenue to drive operating cash flow and the cash flow-to-revenue ratio higher. If revenue declines, the company must make a corresponding reduction in expenses to maintain the same cash flow-to-revenue ratio. Other strategies to increase the ratio include using credit instead of cash for purchases, tightening credit requirements and following up on overdue accounts.
If a company's revenue and operating cash flow are $100,000 and $26,000, respectively, the operating cash flow-to-revenue ratio is 26 percent [100 x ($26,000/$100,000)]. If the company increases revenue by 10 percent to $110,000 [$100,000 x (1 + 0.10) = $100,000 x 1.10 = $110,000], but spends more on advertising and other expenses to generate this incremental revenue, its net income may fall, which means operating cash flow will also fall. Assuming cash flow falls by 5 percent to $24,700 [$26,000 x (1 - 0.05) = $26,000 x 0.95 = $24,700], the new cash flow-to-revenue ratio is 22.45 percent [100 x ($24,700/$110,000)], which is a decline of 3.55 percent (26 - 22.45) in spite of a 10 percent increase in sales.